'The Missing Risk Premium': A Book That Will Change the Way You Think About Trading
By Aaron Brown Sep 10, 2012 11:15 am
Eric G. Falkenstein argues that there is no risk premium and there never was, so conventional investing advice is deeply misguided.
Prior to 1950, when the main historical portion of The Missing Return Premium begins, there was not much consideration of risk premium in finance. There were a few exceptions, such as Louis Bachelier, but to mainstream financiers, a good stock was a stock that went up and a bad stock was a stock that went down. People knew it was hard to tell the difference, so even a good investor bought lots of bad stocks, but those were mistakes rather than the result of risk for which the investor would be compensated in the long run. Investment research meant studying investment fundamentals to pick sound securities, not estimating probability distributions to optimize portfolios. Randomness was noise that made investing more difficult, not the essential basis of investing.
In the conventional account, from 1950 to 1975, starting with Harry Markowitz and ending with Eugene Fama, modern finance discovered and verified a single, universal risk premium that explained everything, leading to a financial version of the Enlightenment. Old wisdom was thoroughly overturned and a new, rational, empirically validated theory explained everything. Even better, this theory fit seamlessly into the current views in economics and meshed with some quantitative researchers in other social sciences. It was beautiful, mathematically consistent and true.
Falkenstein retells this story armed with a skeptical mind and knowledge of subsequent discoveries. It is a selective account, as it has to be to fit into half of a small book, but it is not unfairly selective. That is, while he leaves out many nuances and simplifies much of the argument, he does confront the strongest points in favor of a risk premium. In this version, researchers were drawn to the idea of risk premium for theoretical reasons. Results that confirmed risk premium were cheered without skepticism; results that contradicted it were subjected to vigorous challenge that eventually overturned them.
This is an account everyone interested in quantitative finance should read because it gives a fresh and important look at the formative years of the field. Personally, I wish it had been higher-minded. There is no mention of the attacks on the field from economists and practitioners, and the tremendous practical good done by the research. It suggests a group of self-satisfied ideologues blindly creating evidence for an obviously false theory. In fact this was a group of brilliant, hard-working, skeptical people who questioned every assumption as rigorously as Falkenstein does, but without his benefit of hindsight, and who read and debated internal and external criticism. That the result has so many flaws by modern lights is not a criticism of the researchers but a testament to how hard it is to say anything at all about expected return.
At one point, Falkenstein mentions unnamed people who consider Eugene Fama to be a “lightweight.” When I first read the book, I thought it was smear, hiding behind unnamed sources to say something the author is afraid to say aloud. However, after an email correspondence with the author, I see that he meant the comment to be a criticism not of Fama, but of other academics who were obsessed with theoretical rigor rather than empirical tests. I mention it since it would be an incendiary claim, and other readers may draw the same conclusion as I initially did.
Next, Falkenstein surveys 31 asset classes and investment spreads and finds evidence for positive risk premium in only four (REITs, Equities versus risk-free debt, high-yield bonds versus high quality bonds and short-term treasuries versus longer term). Thirteen show zero risk premium, and 14 show a negative return premium (including high-risk stocks versus low-risk). This is a valuable study, informative and interesting to read. I disagree with some of the specifics, but the overall picture is worth considering.
No positions in stocks mentioned.
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