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

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. There are numerous typos, including at least one where he reverses the meaning in a manner that will confuse most readers and destroy the point he's trying to make. The graphs and tables are important to the argument, but low-quality, and they assume the reader can guess what things like AnnStDev or AvgGeoRet mean. There's not a lot of jargon compared to many books, but too much given the simple elegance of the argument. There is no index.

Falkenstein retells the story of the development of Modern Portfolio Theory, the Efficient Markets Hypothesis and the Capital Asset Pricing Model, armed with a skeptical mind and knowledge of subsequent discoveries. It is a selective account, as it has to be to fit into half of a small book, but it is not unfairly selective. That is, while he leaves out many nuances and simplifies much of the history, he does confront the strongest points in favor of a risk premium. This gives a fresh look at the formative years of modern finance. I wish it had been higher-minded. I thought the low point of this account is when Falkenstein mentions unnamed people who consider Eugene Fama to be a "lightweight," and implies but does not state that he agrees. That appeared to be a smear, but in his comment and an email he explained he did not share the opinion, and disagrees with it. Nevertheless, his book gives the impression that many efficient market researchers were less open-minded, skeptical and willing to challenge their ideas than I believe they were.

Next, Falkenstein surveys 31 asset classes and investment spreads and finds evidence for positive risk premium in only 4, while 14 show a clear negative return premium. The book moves on to a more general historical and philosophic context. Why should mere exposure to risk be rewarded? There are always lots of people willing to do it. Some may even like it, after all, people gamble apparently for pleasure in casinos and dangerous sports and bar fights and lots of other areas in life. But even if everyone found risk distasteful, if people got paid for doing distasteful work then people who clean toilets would make more than professional athletes and movie stars.

Even if people did get paid for taking risk, it would not be for well-understood statistical risk like buying a volatile stock. Real risk is walking into complicated and uncertain situations, for which probability distributions are unknown. And losing money (especially other people's money) is nothing like the pain of being thought an idiot. Defying convention, underperforming the benchmark, being wrong while looking stupid; these are the unpopular forms of pain.

The single most important message in the book, which is also in Finding Alpha, is that expected return is not something you get for passive exposure to known unpleasantness, it is a niche in which you have advantages over other people. Success does not come from combining well-known bets a little better, it comes from making your own bets.

Finally, Falkenstein works out the mathematics of a market in which risk consists of underperforming the average rather than poor gross returns. He justifies this with a variety of arguments, and shows that it results in a zero premium for risk.

Even more interesting, he addresses the flaw that sinks most models without risk premia, he shows that rational, risk-averse investors will not offset the actions of irrational or risk-loving investors.

This is an important book. At worst, the effort you expend to refute its claims will deepen your understanding of conventional models. At best, it will be a breakthrough to a new understanding of financial markets and better investment results. I suspect you'll end up somewhere in the middle, which is a good place to be, especially if you hate to deviate from the benchmark.

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. The author mentions studies which document just such errors (and broader irrationality), but forges ahead with his preferred theory - oddly, Chapter 8 does not mention a single experimental study supporting the author's hypothesis - after quickly dismissing the alternatives in Chapter 7 (the book's weakest, along with Chapter 2).

I am "neutral" on Falkenstein's theory, dissatified with his description of academic consensus, but appreciative of his empirical contribution, on display in Chapter 4.

UPD. I recently came across the Wikipedia page of a Robert Haugen, and read this

With his former professor, A. James Heins, he discovered in the late 60s and early 70s that, contrary to the prevailing theory, low risk stocks actually produce higher returns. The resulting article bestowed on him the unofficial designation of "father of low volatility investing".

The new is the forgotten old...

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.

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.