Book review: The missing risk premium – Eric Falkenstein
Eric Falkenstein might be well know through his Falkenblog. Hi is an outspoken critic of “classical” finance theory, especially the CAPM and its derivatives.
His main thesis is that there is no risk premium for riskier investments.
In his new, self published book (I have read the Kindle version), he starts with the history of the CAPM (MArkowitz &Co).
He the summarizes most of the well known anomalies, which clearly contradict the efficient market /CAPM paradigm such. For me the most interesting anomalies were:
- the highest beta stocks have significantly lower than average returns
- distressed stocks (measured by Rating) have the lowest returns
In “traditional” academic theory, many of those anomalies are often related to behavioural biases, such as lottery tickets etc.
However he goes further, formulating his own theory why a risk premium does not exist. I have to admit that I read quite quickly over that one, but the issue according to him is that one should use relative utility functions instead of absolute utility functions.
At the end, he briefly discusses how one can outperform the market easily with low volatility stocks. One possibility would be minimum variance portfolios (MVP), the other a subset of an Index with stocks which have a beta of around 1.
Additionally he makes a very good point that typical pension fund asset allocation (i.e. allocating into hedgefunds to generate higher long term returns) will most likely not yield the expected results.
+ the book is a good summary of all the current available studies which contradict the CAPM
+ he makes a good case for investing in low volatility assets, although I didn’t fully understand his theory
- what he misses in my opinion is the fact, that all this is common knowledge among value investors.
Value investing doesn’t assume efficient markets and it also ignores stock price volatility as one is concentrating on fundamentals only. So a typical value investor clearly is indifferent about stock price volatility and does not believe that more volatile stocks produce higher returns. Maybe as an academic you need a complicated formula to prove this, as a value practitioner one simply knows that “safe & cheap” stocks will outperform over time.
Overall I would say for a typical value investor, you might not need to read the book. If you are more interested in general financial theory and want to have a good update of the current empirical status then it might be a good investment. The kindle version is actually quite cheap at 8 EUR or so.
For me personally, it somehow validates the result of my “boss” model. The Boss model identifies stocks with low fundamental volatility. Low fundamental volatility very often transforms into low beta, cheap valuation and high potential returns.