From the Inside Flap
In 1992, a long-established finance theory was turned upside down when researchers published a paper in the Journal of Finance
—later cited in the New York Times
—which documented that the main empirical implication of the Capital Asset Pricing Model (CAPM) was untrue: that is, that "beta" was not positively related to stock returns. The article, later corroborated in many subsequent studies, was to be one of the most heavily cited Journal of Finance
articles in its history. The basic model of risk and return that academics had taught for decades was shown to be empirically useless, and subsequent extensions have been successful only by redefining risk merely as anything with a high average return. Since that groundbreaking article was published, practitioners have been left asking: So how do we find alpha if we can't measure risk?
Finding Alpha offers a new approach to finding alpha, backed by current empirical evidence and grounded in the notion that risk and return are not necessarily correlated. Author Eric Falkenstein offers a serious criticism and counterproposal to current financial theory on risk and return that is comprehensive yet understandable to the average person. He argues convincingly for replacing the old assumptions with new ones, primarily replacing greed and introducing another factor—the innate human desire for hope and certainty. Falkenstein clearly shows that once one understands that "risk adjusting" returns, in the sense of adjusting for a priced risk factor, is a red herring, one can search for alpha more productively.
The author brings his theories down to earth with practical applications of alpha-seeking strategies that he developed through his own experience at Moody's Risk Management Services and with his own investment company. But ultimately, as the author shows, alpha is about finding a comparative advantage, both in the financial markets and in life. This means sticking to things you are good at, things you enjoy doing, because those are the things where making that extra effort is costless because it is something you like to do. That is the risk-taking that leads to greater returns. Maximizing your alpha should provide you with not merely a way to maximize your income, says Falkenstein, but also give you the greatest satisfaction, and the most meaning, in your life.
About the Author
Eric Falkenstein, PhD
, developed the RiskCalcTM, the world's leading scoring tool for evaluating private firm default risk, while at Moody's Risk Management Services. The celebrated tool is used by banks worldwide, as well as by regulators and Moody's own CDO group. He was head of capital allocations and quantitative modeling at KeyCorp prior to joining Moody's and later was with Deephaven Capital Management where he developed and managed a long/short equity strategy. Between 1996 and 2002, Falkenstein formed his own investment company, the Falken Fund, which had returns of 16.0% versus 3.8% for the S&P500. His hedge fund activities are ongoing and, by law, proprietary. He is a consultant and a member of CapRock Advisors LLC, a hedge fund advisor.