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The Missing Risk Premium: Why Low Volatility Investing Works Paperback – August 16, 2012

4.1 out of 5 stars 21 customer reviews

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Editorial Reviews

Review

"In this contrarian view of the asset pricing model, Falkenstein attempts to debunk the notion that greater risk equals greater reward...The author's conclusion is likely to be controversial in some circles, if not downright inflammatory" - Kirkus
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Product Details

  • Paperback: 196 pages
  • Publisher: CreateSpace Independent Publishing Platform; 1st edition (August 16, 2012)
  • Language: English
  • ISBN-10: 1470110970
  • ISBN-13: 978-1470110970
  • Product Dimensions: 6 x 0.4 x 9 inches
  • Shipping Weight: 12.5 ounces (View shipping rates and policies)
  • Average Customer Review: 4.1 out of 5 stars  See all reviews (21 customer reviews)
  • Amazon Best Sellers Rank: #980,495 in Books (See Top 100 in Books)

Customer Reviews

Top Customer Reviews

By Aaron C. Brown TOP 1000 REVIEWERVINE VOICE on September 8, 2012
Format: Paperback
Over the last 60 years, the concept of risk premium has embedded itself so deeply in finance that it is hard to think of investing without relying upon it. It's important to separate this idea from merely keeping expected value constant. If a risk-free bond pays 5 percent interest, a bond that might default must pay more than 5 percent just to have the same expected return. So the fact that junk bonds pay higher yields than investment grade bonds does not prove that there is a risk premium. We would need to show that portfolios of junk bonds had higher long-term average returns than portfolios of investment grade bonds, after subtracting out losses from default.

Falkenstein argues that there is no risk premium, and never was, so conventional investing advice is misguided. He has developed a consistent and plausible alternative explanation. This is a valuable argument, even if it is ultimately not correct. You cannot understand risk premium if you think it is obvious, you need to see why it might not exist to see how to look for it.

The book also describes an investment approach, a version of what is generally called low-volatility investing. The author is among the pioneers in this area and he advocates a reasonable version of it.

When I reviewed the author's first book, Finding Alpha, I complained about the $95 list price and suggested it should be $25 list to sell for $15 at Amazon. I don't know if he was paying attention, but if he was, he traded through my bid by a nickel. Unfortunately he didn't listen to my complaints about the copy editing and production values.
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Format: Paperback
The complaints will take more space, so I want to emphasize the praise. This is an original, highly informative, thought-provoking book. Do check it out.

I would group the book's chapters as follows:

* Chapters 2-3 (24 pages), which discuss economists' work on modeling asset risk and return.
* Chapter 4 (53p), which points to poor returns for a number of risky assets and investment strategies.
* Chapter 7 (12p), which surveys common rationalizations of findings similar to those of Chapter 4.
* Chapters 5, 6, 8 (36p), which advance the alternative of modeling investors as caring about their wealth *relative to others*.
* Chapter 9 (8p), which sets out the author's investing approach.

The book's title, "The missing risk premium: why low-volatility investing works", is confusing. Falkenstein's "low-volatility investing" means, on different pages, either avoidance of high-volatility stocks, or selection of the minimum-volatility portfolio in a Markowitz problem (not so contrarian after all), or a combination of both. If it works, it isn't because of a missing risk premium, as neither the deceased straw man of CAPM (whose introduction in Chapter 2 omits a list of assumptions, which most textbooks feel obliged to state and discuss), nor its multifactor nephews, posit a risk premium for total volatility in the first place.

Underperformance of a priori "risky" assets (if conclusively shown) does not immediately imply a negative risk premium, if systematic expectational errors - or, trivially, risk-loving preferences, if we choose to remain in the rational-expected-utility-maximizer framework - have not been ruled out.
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This book offers an incredibly high ROI to a finance professional. It offers an integrated theory of the non-correlation of risk and return, while providing evidence supporting that theory. And then offers some practical implications, given this theory. What intellectually active finance professional wouldn't be interested in whether the CAPM fails to reflect reality? That the slope of beta is likely either insignificant or negative over the long run?

Falkenstein is a "quant" but makes the book accessable for readers who are non-quants. Quants who are interested in this topic and have read his earlier book are probably already reading other quant papers on the subject, and doing their own research on how to best exploit its implications. Or they've already set up investment vehicles.

Note that recognizing the merit of Falkenstein's work requires much less effort than actually doing something about it. Not because it is technically difficult to build lower risk investment portfolios, (though it does require some effort), but rather because there are significant behavioral and institutional obstacles to overcome in putting these theories into practice. Foremost is fear of tracking error. Which is why Falkenstein's theory will likely remain useful over the longer term.
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Mr. Falkenstein has some interesting ideas but, his book is badly in need of a first rate professional editor. He doesn't always keep in mind that his readers are: A) not all PHDs in finance, B) all interested in his legal problems, C) interested in understanding his good and useful ideas without struggling with the author's convoluted prose. Get this book for the ideas but be ready to work to tease them out.
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