The Missing Risk Premium takes aim at a central premise of modern finance theory: extra return requires extra risk. The premise is so central that few of us involved in modern academic finance can even imagine a world without it. Eric Falkenstein insists that we do. This book is his challenge to us.
Falkenstein’s thesis is a radical one: extra risk does not yield extra return.
This book is the product of many years of engagement on the subject by Falkenstein. Back in 1994, in his Ph.D. dissertation, Falkenstein documented the paradoxical fact that low volatility stocks have had higher return than high volatility stocks. This fact is now widely known, but not when he first noticed it.[1] It is also difficult to reconcile with received finance theory. One way to resolve the conflict is to minimize, dismiss or simply ignore the fact. Alternatively, one can take the fact seriously and question the theory, as Falkenstein has done.
Questioning the theory is a tough challenge, though. As already mentioned, the risk premium is a central premise, and modern finance theory is a ramified structure. If we remove that premise, there is a lot of work to be done to recreate the structure around an alternative. I was surprised to find that Falkenstein understands the burden his questioning entails, and this book is a partial attempt to flesh out an alternative. Falkenstein is a serious fellow, and he has engaged the problem persistently over many years, so it is interesting to listen to his suggestions.
In this book, he provides a lucid history of the academic thinking on risk and return over more than a half century, a careful exposition of what the data say and don’t say, and a thoughtful discussion of competing theoretical frameworks. He writes with the refreshing voice of an outsider, and looks upon academia with a gimlet eye. But he also writes with the qualifications of an insider, completely familiar with the most sophisticated economic theories and statistical tools. He assumes the burden of making his critique and ideas resonant to an open minded intellectual familiar with modern economics. Make no mistake, this is a wonkish book that places serious demands on its readers.
The subtitle is unfortunate. It makes this book sound like an investment guide, which it isn’t. But Falkenstein does inhabit the investment management world, and it is a distinct subculture of finance and the biases of that subculture show in the content of the book. It is focused almost exclusively on the problem of designing a portfolio of stocks, bonds and other tradable securities. The broader context of financial decision making gets no mention. Corporate finance makes no appearance, for example. We still don’t know whether Falkenstein’s alternative for the structure of finance theory can support all of the other branches. He hasn’t yet confronted the full scale of his burden.
This first draft of Falkenstein’s alternative theoretical structure also contains apparently inconsistent design elements. On the one hand, he develops a model in which the equilibrium has no risk premium. But he simultaneously puts in the forefront of his worldview a sea of individuals who act irrationally—outside of the equilibrium of his model—and who generate a negative risk premium. OK, the world is a complicated place, and maybe both are operative. But it isn’t obvious that he means the two to share the stage. That brings its own complications which this book doesn’t address.
[1] A search back through the literature, informed by hindsight, can find other cases in which various academics stumbled over this fact, but Mr. Falkenstein is one of the first to have plainly stared it in the face.
