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Finding Alpha: The Search for Alpha When Risk and Return Break Down 1st Edition

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ISBN-13: 978-0470445907
ISBN-10: 0470445904
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Editorial Reviews

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.

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Product Details

  • Hardcover: 298 pages
  • Publisher: Wiley; 1 edition (June 29, 2009)
  • Language: English
  • ISBN-10: 0470445904
  • ISBN-13: 978-0470445907
  • Product Dimensions: 6.3 x 1 x 9.3 inches
  • Shipping Weight: 1 pounds (View shipping rates and policies)
  • Average Customer Review: 3.8 out of 5 stars  See all reviews (10 customer reviews)
  • Amazon Best Sellers Rank: #1,081,380 in Books (See Top 100 in Books)

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More About the Author

Eric Falkenstein received his economics PhD from Northwestern in 1994, and wrote his dissertation on the low return to high volatility stocks. He set up a Value-at-Risk system for trading operations at KeyCorp, then a firm-wide economic risk capital allocation methodology. He created RiskCalc(TM), Moody's private firm default probability model, the most popular private firm default model in the world. He has been an equity portfolio manager, and currently works on trading algorithms for Walleye Software. Eric has been published in several journals, including the Journal of Finance, The Journal of Fixed Income, Derivatives Quarterly, and others. He blogs at, and has published papers at He lives in the Minneapolis area with his wife and three children.

Customer Reviews

Most Helpful Customer Reviews

59 of 61 people found the following review helpful By Aaron C. Brown TOP 1000 REVIEWERVINE VOICE on July 21, 2009
Format: Hardcover
Edit: I'm not going to rewrite this review, it's an honest account of what I thought after reading the book. But I've raised the rating to five stars and want to add the comment that I appreciate it more after letting it settle for a year, and after rereading some parts. I still think it's sloppy and doesn't give enough credit to others, but I take back the mean line about not having read the references and not understanding Minksky (I think I must have been a bit mad after wading through the sloppiness). On further reflection, the good points have grown better while the flaws remain the same.

What I like about this book:

* It contains important new ideas that can help any risk-taker with quantitative skills succeed
* It challenges conventional wisdom
* The meat of the book is based on practical experience, not just things that seem right to the author, but things he has tried, and generally with success

What I don't like about this book:

* $95, this should be a $25 list book available for $15 on Amazon and $9.99 Kindle
* Sloppy argument and editing, to the point that some passages are not intelligible (doubly annoying in view of the first criticism)
* Lack of appreciation for other people's thought, which leads to missing useful links

An example of the sloppiness (and there are many) is on page 21, "The key to the portfolio approach is the variance of two random variables is less than the sum of their variance." This makes no sense. He might mean "The variance of THE SUM of two random variables is less than the sum of their varianceS," but this is true only if their covariance is negative, while portfolio theory is more concerned with the positive covariance case.
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25 of 26 people found the following review helpful By Andrew West on July 28, 2009
Format: Hardcover Verified Purchase
Eric Falkenstein's book Finding Alpha is a thought provoking book that focuses on the most important issues for a financial practitioner - risk and return. He integrates a variety of research and data sources, some of which are his own, into an unexpected, yet coherent worldview, namely that risk and return are not generally positively correlated.

Falkenstein reaches four basic conclusions:
For most assets, the rate of return is unrelated to its volatility.
Really safe assets have below average returns
Really volatile assets have below average returns
Investors are overconfident, creating excess costs and position concentration.

He argues that this is because:
People are more envious than greedy (i.e. they are more concerned with their position relative to others than in their own absolute wealth.)
People are willing to accept risks in return for the hope (often unfounded) of outsized gains, in investing and other aspects of life.
People save some money in supersafe assets to avoid the chance of losing everything.

Chapter 1 asserts that the common belief that risk begets return (as assumed by most economists and the CAPM) is wrong. He argues that "risk tolerance [in financial markets] is not like physical courage, the ability to withstand a physical pain, but rather like intellectual courage, the ability to withstand ridicule. He argues that finance needs a paradigm shift from CAPM, which doesn't even approximately fit the data, but which dominates the conceptual frameworks of academia and finance practitioners.

Chapter 2 presents the history and derivation of CAPM and later generalizations such as APT, and points out that all share the same basic assumptions about risk aversion.
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12 of 12 people found the following review helpful By S. E. Nelson on November 18, 2009
Format: Hardcover
The problem with this book is that there is really only three messages and each could have been well covered in a 25 page chapter. The first message is that CAPM, APT and related models do not work in the real world. The author instead spends over a hundred pages dismissing the models and the academia that adhere to them in what borders on hysterical ranting. The second message is that investors holding highly volatile assets are probably not getting enough return to justify holding those assets. The author brings this up in an early chapter and then makes one wait 150 pages to back up his proof on this idea. Finally there is the idea that alpha is usually shrouded in secrecy and cannot be easily discerned. It is insightful discussion but the title is very misleading because this is not a book presenting techniques for looking at portfolios managers or investments (other than the volatily - return discussion). The author tries to save himself with some great insights from his broad financial work experience into how the financial community operates. Very smart guy but you wonder if he would be the life of the cocktail party or the guy who traps you in the corner with a dreadful drawn out story. Unfortunately he seems to have had no help from the editor such that the books seems to be continuously heading off on tangents. While very enjoyable in places, this book was too much work and jumped around too much for the limited return it provided.
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5 of 5 people found the following review helpful By David Merkel on January 23, 2010
Format: Hardcover
I found this book both easy and hard to review. Easy, because it adopts two of my biases: Modern portfolio theory doesn't work, and the equity premium is near zero. Hard, because the book needed a better editor, and plods in the middle. I don't ordinarily do this, but I felt the reviews at Amazon were valuable, particularly the most critical one, which still liked the book. I liked the book, despite its weaknesses.

One core idea of the book is that risk is not rewarded on net. It doesn't matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds). Junk underperforms investment grade bonds on average. Lower beta and standard deviation stocks overperform on average.

A second core idea is that some people are so risk averse that they only accept the safest investments, which leaves investment opportunities for those that are willing to compromise a little with credit quality or maturity. Moving from money markets to one year out is an almost riskless move for most, and usually adds a lot of excess return. Bond ladders do the same thing, though Falkenstein does not discuss those.

Also, the move from high investment grade to low investment grade does not involve a lot more investment risk, but it does offer more yield on a risk adjusted basis.

A third core idea is that equities, though more risky than high quality bonds, have not returned that much more than bonds when the returns are measured properly. See this post for more details.

A fourth core idea is that people are more willing to take risks to be wealthy than theory would admit. Most of those risks lose money on average , but people still pursue them.

A fifth core idea is that alpha is hard to define.
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