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'The Missing Risk Premium': A Book That Will Change the Way You Think About Trading

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Eric G. Falkenstein argues that there is no risk premium and there never was, so conventional investing advice is deeply misguided.

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MINYANVILLE ORIGINAL Over the last 60 years, the concept of risk premium has embedded itself so deeply in finance that it is hard to think of investing without relying upon it. Like the man who drinks water all his life and so thinks it has no taste, many people treat arguments based on risk premium as obvious because they have been ubiquitous in finance for so long. For example, many people wouldn't think twice before agreeing to statements like:

  • Since conservative investors prefer low-risk portfolios, assets that add a lot of risk to portfolios have to carry a higher average return than assets that are either low-risk or uncorrelated with conservative portfolios.
  • Since levering an investment increases its risk, it should also increase its expected return.
  • If the risk of an investment goes up and there is no change to its expected future value, its price today should go down.
It's important to separate this idea from merely keeping expected value constant. If a risk-free 10-year bond pays 5% interest, a bond with a 10% chance of default must pay approximately 6% (the exact number depends on the timing of potential defaults and the size of potential recoveries) just to have the same expected value as the risk-free bond. To have a risk premium, the risky bond would have to pay more than 6%, so that its expected return was higher than that of the risk-free bond. In other words, the fact that junk bonds sell for higher yields than investment grade bonds does not prove that there is a risk premium. We would need to show that portfolios of junk bonds had higher long-term average returns than portfolios of investment grade bonds.

Eric G. Falkenstein argues that there is no risk premium, and there never was, so conventional investing advice is deeply misguided. More important, he has developed a consistent and plausible alternative explanation. This is a very valuable argument, even if it is ultimately not correct. You cannot understand risk premium if you think it is obvious, you need to see why it might not exist to see how to look for it. And, of course, if the argument is correct, it is even more valuable.

The book also describes an investment approach, a version of what is generally called low-volatility investing. The author is among the pioneers in this area and he advocates a reasonable version of it. However you need not accept his argument to take advantage of the insights that led to the general development of low-volatility investments. There are different theories out there to explain why it works. Falkenstein, in my opinion, has the boldest plausible explanation, but even if he is correct, that doesn't mean it leads to the best practical portfolio advice or the best investment products (of course, it also doesn't mean the contrary). Theory is important, but implementation details like fees, expenses, taxes, execution quality, data quality, and dozens of others are more important. So just because you like this book doesn't mean low-volatility investing is for you, and just because you like low-volatility investing doesn't mean you have to like this book.
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
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