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.


  • I strongly advocate volatility and beta in a context of general market conditions. So beta in downmarkets is what I am interested in. There are these comps, look at Nemetschek for example which showed a very high beta up til early 2009 although it is a high quality / stable comp. Just one example, but illustrated how fundamental stability can be thrown overboard in the case of smallcaps whenever liquidity dries up.

  • mmi: it is interesting how perception differs. If I have a fundamentally low-volatility company, I actually really like stock vola. This allows me to buy from and sell to freaky mr market more often. I actually see vola as a positive.

    robert: I always liked the explaination that some asset classes show risk premia because they perform badly in “bad times”, i.e. stocks perform the worst when you need it the least :)
    Same for other strategies with a hard-to-explain risk premium, like short near-term vola / long long-term vola, credit basis, writing protective puts etc..
    You make money 90% of the time but when the party stops you get kicked out very quickly…

  • I believe you are totally right. But if you are right there is an interesting puzzle: If there is no risk premium, why do stocks better than bonds?

    In my opinion the main reason is, they do because most investors are restricted to invest in fix-income assets. Similar restrictions exist in the stock market and should create interesting anomalies. E.g. Most non-professional investors restrict themselves to invest in the commonly known stocks.

  • It depends against what you calculate your beta.
    If you employ risk management your portfolio won’t go up as high as the best index of this year, but you can have lower volatility and lower downside.

  • I was amazed by the non-consequential reasoning Falkenstein applied in his book. He rallies against CAPM but in the end recommends something very similar. In fact, he states that excess return is correlated to low-beta whereas CAPM says excess return is caused by high beta. This is not all so different like he wants us to believe. It is just that CAPM as empirical fact on its side before 1970 and Falkenstein on his side after 1970. The “official” finance explaination (institutionals trade after information ratio and not return) at least to me does not intrinsically explain the “low-beta alpha”, does it?

    Whenever I read you (no offense!) write about “stock XYZ also has a low beta which is good” I happen to shiver. I just don’t get it! What is the past reaction of investors in a given stock relative to market moves telling me about their future reaction? What about empirical fact about correlations going up during time of short liquidity / rising risk premia? Why should a given stock be exempt from this if it was in the past?

    Enlighten me!

    • sorry to make you shiver and i am not sure if I can enlighten you…

      However in my experience, most investors hate low beta stocks because you underperform quite significantly when stocks go up. I buy this part of Falkensteins argument, that high beta stocks most of the time trade at a premium (lottery ticket) whereas low beta stocks most of the time trade at a discount.

      After a crash, this is mostly not true.

      So what I am aiming is are stocks with low fundamental volatility, if they show low historical price volatility, it is “good” but I would also buy a cheap stock with low fundamental volatility and high price volatility.

      Howver I have to confess that high price volatility sometimes makes me nervous….

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