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Eric Falkenstein
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The Missing Risk Premium: Why Low Volatility Investing Works Paperback – August 16, 2012

by Eric G. Falkenstein (Author)
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Risk is the deviation from the consensus rather than an exposure to a covariance, and this implies there is no risk premium in general. It also implies that when there are a large number of people buying highly volatile assets, such assets will have negative returns in equilibrium. As there are several independent motivations for people to buy highly volatile assets, intuitively risky assets generally have lower-than-average returns. This novel conception of risk implies many things more consistent with the data than the current theory. Risk taking is an important life skill, so understanding its nature is important, and unfortunately academics who study it full-time are like so many other experts: when not irrelevant, 180 degrees wrong. This book explains the current asset pricing theory, and proposes an alternative, using theory and a unique survey of the data across many asset classes. Familiarity with some MBA level finance is helpful but not necessary to appreciate this book.
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  1. Print length
    196 pages
  2. Language
    English
  3. Publication date
    August 16, 2012
  4. Dimensions
    6 x 0.45 x 9 inches
  5. ISBN-10
    1470110970
  6. ISBN-13
    978-1470110970
  7. See all details
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Editorial Reviews

Review

"In this contrarian view of the asset pricing model, Falkenstein attempts to debunk the notion that greater risk equals greater reward...The author's conclusion is likely to be controversial in some circles, if not downright inflammatory" - Kirkus

Product details

  • Publisher ‏ : ‎ CreateSpace Independent Publishing Platform; First Edition (August 16, 2012)
  • Language ‏ : ‎ English
  • Paperback ‏ : ‎ 196 pages
  • ISBN-10 ‏ : ‎ 1470110970
  • ISBN-13 ‏ : ‎ 978-1470110970
  • Item Weight ‏ : ‎ 9.4 ounces
  • Dimensions ‏ : ‎ 6 x 0.45 x 9 inches

About the author

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Eric Falkenstein

Eric Falkenstein

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Eric Falkenstein received his economics PhD from Northwestern in 1994, and wrote his dissertation on the low return to high volatility stocks. He set up a Value-at-Risk system for trading operations at KeyCorp, then a firm-wide economic risk capital allocation methodology. He created RiskCalc(TM), Moody's private firm default probability model, the most popular private firm default model in the world. He has been an equity portfolio manager, and currently works on trading algorithms for Walleye Software. Eric has been published in several journals, including the Journal of Finance, The Journal of Fixed Income, Derivatives Quarterly, and others. He blogs at falkenblog.blogspot.com, and has published papers at www.efalken.com/papers. He lives in the Minneapolis area with his wife and three children.

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  • l
    5.0 out of 5 stars Falkenstein takes a mighty empirical sledghammer to investment theory political correctness and strikes gold
    Reviewed in the United States on October 31, 2012
    Verified Purchase
    Falken has delivered a mighty death-blow to the pet theory of the Shaman and High priests of Academic finance, who for far to long have based their many intricate mathematical models upon a base no more solid than an excrement-filled pool of quicksand. The notion that risk is inherently compensated is thoroughly, devastatingly debunked by a mighty mountain of hard empirical evidence. The "modern financial theory" viewpoint on risk will go down as one of the great crank-theories of all times, if truth and justice are to win out (And they always do in the end).

    Indeed, Falkenstein's machine-gun style assault on this "pet theory" of finance professors everywhere will go down as a great case study of the, "Emperor has no clothes" phenomenon - only this time it is not child calling out truth, it is a muscled he-man armed with a mighty empirical cannon.

    After running conventional wisdom through an enormous wood-chipper, Falken then moves on to develop a counter-theory that takes into account his research findings. For me it all seemed obvious, but only in the sense that once informed his ideas seem completely intuitive.

    I found the most interesting part of the book (even above and beyond his empirical data and alternative theory) to be the many interesting facts and personal observations Falkenstein makes. I had a note pad by my bed (read it on the Amazon kindle IPhone app before turning out the lights each night)to jot down notes so that I could research some of his statements further.

    In some parts the book reads like a personal statement. I felt like Falkenstein was talking directly to me as an individual, which is a unique viewpoint for a book grounded in academic research.

    I also enjoyed his explanation as to why the bogus "risk-return" viewpoint has lasted for so long. There is truly an "institutional imperative" that has defended and protected this misleading theory for far to long - and quite frankly I think Falken lets the witch doctors and shaman of modern finance off far too easily.

    But then again, by all measures he seems to be a decent fellow - Not the type to harbor a grudge even though the finance-cranks shut him out of a traditional academic career. Falken displays the wisdom of a man who knows this is the fate of those who part ways with "the received wisdom of the high priests" no matter how bogus and debunked their pet notions might be. "Stoic" best describes his approach to the entire subject.

    In conclusion, Falkenstein (regardless of his intent) has exposed academic finance to be (a least in part) a sterile, irrelevant vacuum of serial math-terbators. It has become so bad that practitioners (elite financial professionals) now prefer to hire hard science majors whos brains and viewpoints have not been warped by the witches brew of modern financial theory.

    On a personal note, I myself have benefited from Falkenstein's insights. Indeed, I learned about him via his blog, which I was referred to by a top notch hedge fund trader who specializes in options. I was told, "falkenstein is good people" and I am inclined to agree. After reading his blog(and being convinced by the evidence) I decided to invest almost exclusively in lower risk assets and stocks (Any area where I am not testing or applying what I think might be a real advantage). I could not be happier. I love seeing the market down 1% while my stock holdings are down just fraction of that.

    In conclusion, I can't recommend this book highly enough.
    4 people found this helpful
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  • A. Martin
    4.0 out of 5 stars A top 5 investment book
    Reviewed in the United States on June 2, 2013
    Verified Purchase
    The Missing Risk Premium is an important book, and at times quite entertaining and betrays a gifted intellectual reach.

    The author is correct in disconnecting risk from return, and he presents the data and the theory to support it. This is a vital message and one that should be read by money managers, investment advisors, pension managers, anyone who sits on an investment committee, and intermediate to advanced investors. I underlined and dog-eared many passages in the book and will use it in my own research. It helps that I agree with him on virtually everything. I believe his criticism of the state of investment research and practice is on target. CAPM models and their derivations are simply leaping off points, but their premises and assumptions are elementary to the point of uselessness.

    Chapter 4, 'A Survey of Empirical Evidence' is the heart of the book, and indeed the longest chapter where is compared expected returns of investments as far ranging as IPOs, penny stocks, and mutual funds to private equity, corporate bonds, futures, and even movies, sports books, and lotteries. It is an engaging chapter where if read with the introduction would be enough to get the point.

    The book would rank 5 stars to me if at times the language was not so dense. Though I have studied economics, am a fund manager, and an investment writer/researcher I was frustrated with the frequent use of terms like "consumption," "agent," "utility," "status," and other cumbersome words from econ class. Rather, with Mr Falkenstein's wit and strong mind he might have been more illustrative. I also found the discussion about greed vs envy tangential. Perhaps that concept needs its own book.

    All in all, an excellent effort. I usually do not enjoy investment books. I find most investment white papers and books to be dreary. The Missing Risk Premium is a winner.

    Write something else Eric!
    6 people found this helpful
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  • Gregory Fodor
    5.0 out of 5 stars A must read.
    Reviewed in the United States on October 2, 2012
    Verified Purchase
    As an individual investor dabbling in quantitative finance, this book was eye-opening. Value investors, Buffett included, have often taken issue with the academics' claim that risk is volatility. It wasn't until I came across this book that I found someone who was willing to prove it.

    The book's main thesis is that there is no risk premium for volatility. Beyond simply providing subjective evidence, and without spoiling the book's argument, the author attempts to alter the foundational utility function in investment decision making to show that the risk premium is an illusion. This has profound implications for finance if true.

    As a newcomer to quantitative finance, I found this book to be a valuable, well referenced survey of the field. This survey and the book's references is worth the price of the book alone. Beyond that, the case made for the illegitimacy of the risk premium is strong subjectively, empirically, and mathematically. And, if that wasn't enough, the author shares his methodology for constructing optimal portfolios that minimize volatility, since you are not being paid for it.

    All in all this book is a must read. It's clear the author cares deeply about this subject and has been thinking about these things for many years. Generally speaking books that question long-held truths are often full of sloppy arguments by people who don't know what they're talking about. That's not the case here.

    Even if its core thesis turns out to be incorrect, simply imprinting some healthy skepticism of CAPM and the risk premium onto the minds of investors will pay dividends.
    3 people found this helpful
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  • Dr. Gurbachan Singh
    5.0 out of 5 stars Buy it
    Reviewed in India on October 18, 2016
    Verified Purchase
    I strongly recommend this book - not because I am entirely convinced (with first reading) but because it is fresh, thoughtful, penetrating and yet rather simple and far reaching.
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  • Dr. Chrilly Donninger
    3.0 out of 5 stars Der verkannte Prophet
    Reviewed in Germany on March 17, 2013
    Verified Purchase
    Der Autor kam in seiner 1994 erschienen Diss. zum Schluß, dass es keine systematische Riskoprämie gibt. Aktien mit großem beta haben keine bessere Performance als jene mit geringer Volatilität. Diese These war im Widerspruch zur damals herrschenden CAPM-Theorie. Er wurde nach seinen Schilderungen zum outlaw erklärt. Inzwischen ist diese These zumindest in einigen Bereichen weitgehend akzeptiert. S&P hat mehrere Low-Volatility Indizes kreiert. Es gibt Low-Volatility ETFs wie z.B. den SPLV (S&P-500 Low Volatility). Der SPLV hat seit seinem Bestehen eine bessere Performance als der SPY. Der Autor wälzt dieses Thema - und die Ungerechtigkeiten die ihm widerfahren sind - in 8 Kapiteln auch breit aus. Allerdings kann er nicht besonders gut erklären und sind manche Aspekte wie z.B. die Ausführungen über Utility-Funktionen für das Traden weitgehend irrelevant. Viele seiner Argumente sind ein Schattenboxen gegen die herrschenden Dogmen der 1990er Jahre.
    Die schlechte Performance von high-beta Assets lässt sich auch aus dem volatility-drag erklären. Dieser Effekt tritt deutlich bei Leveraged-ETFs in Erscheinung. Wenn sich der Basis ETF seitlich bewegt, verliert der Leveraged-ETF auf Grund des drags. Falkenstein geht auf diesem Punkt, der unmittelbar aus den Eigenschaften einer Brownschen Bewegung folgt, nicht ein. Wahrscheinlich fehlen ihm die mathematischen Kenntnisse, möglicher Weise liegt es auch an seiner etwas antiquierten Perspektive. Leveraged ETFs und ihre Eigenschaften sind eine relativ neue Entwicklung [1].
    Das letzte Kapitel betitelt sich "Practical Implications". Dieses Kapitel ist vage gehalten, die Beschreibung hat erhebliches Verbesserungspotential.

    Meiner Meinung nach gibt es auf manchen Teilgebieten sehr wohl eine Risikoprämie. Z.B. notieren VIX-Futures in der Regel über den VIX und es lassen sich daraus gewinnbringende Strategien entwickeln [2],[3]. Dasselbe gilt für SPX-Optionen [4],[5].
    Das Buch enthält ein paar interessante Hinweise, es ist nicht besonders dick und auch preiswert. Es leidet allerdings an der nostalgischen Larmoyanz des Autors.

    [1] Ch. Donninger: Leveraged ETF-Trading: The Johnny Walker-Strategy, Sibyl-Working-Paper, Revision-1, 2012.07.29 [...]
    [2] David P. Simon, Jim Campasano: The VIX Futures Basis: Evidence and Trading Strategies. June 27, 2012
    [3] Ch. Donninger: VIX-Futures Basis Trading: The Calvados-Strategy, Sibyl-Working-Paper, Feb 2013
    [...]
    [4] Lucia Del Chicca, Gerhard Larcher, Michaela Szoelgyenyi: Modeling and Performance of certain Put-Write Strategies
    [5] Ch. Donninger: SPX-Options-Trading: The Kir Strategy, Sibyl-Working-Paper, Rev. 2, 2013.03.08
    [...]
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  • Book fan
    5.0 out of 5 stars Thought provoking
    Reviewed in the United Kingdom on September 20, 2012
    Verified Purchase
    Excellent book which convincingly argues that the current assumptions presently taught about the payoffs to taking risk in the stock market are wrong.

    The book is comprehensive enough to make the case convincingly but not too long to bore the reader. I particularly liked the diversions into anthropology and psychology. I have a PhD in economics and can't fault his arguments. A book making a similar case is Steve Keen 'Debunking Economics' which is also good.Hats off to Mr Falkenstein!
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