'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.
The book moves on to a more general historical and philosophic context. Why should mere exposure to risk be rewarded? There are always lots of people willing to do it. Some may even like it, after all, people gamble apparently for pleasure in casinos and dangerous sports and bar fights and lots of other areas in life. But even if everyone found risk distasteful, if people got paid for doing distasteful work then people who clean toilets would make more than professional athletes and movie stars.
Even if people did get paid for taking risk, it would not be for well-understood statistical risk like buying a volatile stock. Real risk is walking into complicated and uncertain situations, for which probability distributions are unknown. And losing money (especially other people’s money) is nothing like the pain of being thought an idiot. Defying convention, underperforming the benchmark, being wrong while looking stupid; these are the unpopular forms of pain.
The single most important message in the book, which is also in Finding Alpha, is that expected return is not something you get for passive exposure to known unpleasantness, it is a niche in which you have advantages over other people. Success does not come from combining well-known bets a little better, it comes from making your own bets.
Finally, Falkenstein works out the mathematics of a market in which risk consists of underperforming the average rather than poor gross returns. He justifies this with a variety of arguments, and shows that it results in a zero premium for risk. This is an important result, even if you disagree with the assumptions or think the empirical predictions are false.
Even more interesting, he addresses the flaw that sinks most models without risk premia, he shows that rational, risk-averse investors will not offset the actions of irrational or risk-loving investors. In conventional models, if some investors bid up the price of an asset beyond equilibrium values, smart investors will reduce holdings or short the asset, quickly restoring equilibrium. In Falkenstein’s model, arbitragers may reduce holdings in the overpriced assets, but will not short them, and will not reduce holdings enough to restore the equilibrium price. I believe this is an accurate description of financial markets, although I’m not sure that Falkenstein’s model for it is correct.
One interesting thing to me is Falkenstein’s equation 5.34, which shows the expected return investors demand on an asset increases with the fraction held by other investors. I come up with the identical formula in chapter 5 of Red-Blooded Risk. Mine is stated inversely; I show the expected return decreases with the fraction the investor herself holds. The two are mathematically equivalent. Falkenstein’s version is a consequence of investors caring only about relative performance. My version comes from the assumption investors hold Kelly-optimal portfolios and ignore not only all other investors, but all other potential investments. I doubt there is a deep economic connection between our models, I suspect it is a case that certain simple relations pop up in different contexts. Like most applied mathematicians, however, I instinctively trust work when familiar relations appear naturally. It doesn’t mean you’re right, but when you are right, you usually get things with obvious parallels to other right things.
The Missing Risk Premium is an important book. At worst, the effort you expend to refute its claims will deepen your understanding of conventional models. At best, it will be a breakthrough to a new understanding of financial markets and better investment results. I suspect you’ll end up somewhere in the middle, which is a good place to be, especially if you hate to deviate from the benchmark.
No positions in stocks mentioned.
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