Bayesian Investor Blog

Book review: Finding Alpha: The Search for Alpha When Risk and Return Break Down by Eric Falkenstein.

This book presents mostly convincing arguments that refute the basic principle of CAPM that riskier investments are rewarded with higher returns, and the relation between risk and returns is better explained by modeling investors as wanting high returns relative to other investors rather than high absolute returns. But the quality of the arguments is quite variable. Much of the book assumes a good understanding of finance theory. If you don’t understand the importance of a Sharpe ratio, you’re not in his target audience.

I was not convinced by his most heavily emphasized empirical claim, that returns on equities are unrelated to beta because controlling for size eliminates the apparent relation. There’s enough connection between size and risk that this raises many questions he doesn’t answer (e.g. JB Berk, A critique of size-related anomalies). But later on he devotes a chapter to a wide variety of evidence that overcomes these concerns, and somewhat supports his claim that for riskier investments, the correlation between risk and return is negative (for the safest investments, it’s positive). And the authoritative Fama and French paper has more convincing evidence about beta – even without controlling for size, the correlation between beta and returns vanished during the 1963 to 1990 period.

He claims that the equity risk premium is effectively zero for a typical investor. His attempt to add up the different adjustments is confusing. He concludes with a table showing size adjustments to that standard estimate that add up to a mind-boggling 15 percent, which would result in a “premium” of -9 percent or so. But adding them is clearly wrong – the tax adjustment assumes the absence of some of the other adjustments. Still, the arguments he assembles from other researchers imply a good chance that the sign of the equity risk premium varies with the time period over which it’s measured.

He suggests some strategies to invest more wisely as a result of the ideas he presents, which he aptly summarizes as “selling hope relative to the market” (i.e. treating volatile stocks as overpriced due to a hope premium). But claiming this produces “superior returns, with less risk however measured” is too strong. Financial risk is not the only relevant measure of risk. Following his advice has social risks that he hints at elsewhere. Being invested in boring stocks in a bubble impairs your ability to engage in some interesting conversations, and you won’t make up for that by mentioning how you outperform the market in times when other want to avoid remembering their investments. Is it possible to minimize both kinds of risks by investing token amounts in ways that trendy folks are talking about, and investing most of your money to maximize your Sharpe ratio? Or does that require too much cognitive dissonance?

The book encourages pessimism, especially about the effects of people wanting relative wealth, and makes disturbing claims such as “Envy is necessary for compassion”.

He provides a number of other good ideas about investing, such as the possibility that the internet bubble adds a big anomaly to many data sets used for backtesting.