Eric Falkenstein

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In general, risk is not related to return

At very low risk, there is a positive risk-return trade-off effect

At very high risk, there is a negative risk-return trade-off

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about Risk, Return, and Alpha

I’m an economics PhD who has worked as a quant, risk manager, and portfolio managerwww.defprob.comwww.efalken.comfalkenblog.blogspot.com

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TA for Hyman Minsky in 1986Risk essence of interesting

economics, undefinable1994 dissertation documented

volatility and returns inversely related

Scope of evidence accumulating to a critical point

Present theory why risk not related to return in general

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After 45 years, there are no measure of risk that are generally positively correlated with returns

Fama and French 1992

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Theory: Longer hair people are short Omitted variable: gender

Theory: high beta firms have high returns Omitted variable: size

Fama-French rebrand ‘anomalies’ as ‘risk factors’No anomalies!

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Oil pricesConsumption growthPer-capita labor incomeConsumption/wealth ratioStatistical (latent) Factors

Etc.

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"Risk is not an add-on … it permeates the whole body of thought.“

Robert C. Merton

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1FVPVr g

g PV

g PV

“most returns and price variation come from variation in risk premia” John Campbell

Finance is “the only part of economics that works”

Andy Lo

finance economics > sociology10

Derivatives: risk neutral expected value

Efficient Markets: hard to make money

‘it would be irresponsible to assume that [the CAPM] is not true’

William Sharpe

‘theoretical tour de force’ though ‘empirically vacuous’

Eugene Fama

‘stochastic discount factor(s) … so general, they place almost no restrictions on financial data’

John Campbell11

75 % of finance professors would recommend using the CAPM for capital budgeting,

10 % the Fama-French model, 5 % some unspecified APT Why use it?1)CAPM ‘works’ if we ignore small firm effect2)Everyone (ie, academic finance) does it3)What else should we do?4)Intuitive (it should work)

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Ivo Welch

Risk aversion like aversion to smellinessIs mathematically consistent

Given assumptions, asset pricing theory is correct

CAPM special case of APT and SDF theoryLike physics: mathematical beauty leads to

truth

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Leveraged FirmsB vs. BBB rated BondsOut-of-the-money options vs. at-the-money

optionsS and C corps vs. equity indexesHighest volatility vs. modest vol stocksR rated movies vs. G rated moviesLotto vs. ‘quick pick’ lotteries50-1 horses vs. 3-1 horses Mutual funds, currencies, futures, countries,

yield curve14

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Low volLow betaProfitableUnlevered

High volHigh betaUnprofitablelevered

“Risky?” “Safe?”

“Beautiful?”

Nobody charges differently for capital within a bankMortgagesreal estatecredit cards

Hedge fund: funding rates the same for distressed lendingConvertible bondspairs

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Relative Utility no general risk premiumInstead of maximizing income, where each

dollar is worth less to us, we maximize our status.

All risk like idiosyncratic risk, unnecessary so unpriced

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“I want a product to be defined relative to a benchmark”

Bill Sharpe‘Risk, see Benchmarking’Kenneth Fisher’s Only Three Questions that

Count

“small stocks were in a depression” in the 1980’s

Eugene Fama

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“I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. So I split my contributions fifty-fifty between stocks and bond”

Harry Markowiz

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People pay for hope highly ‘risky’ assets generally have lower returnsLottery returnshigh vol stocksJunk bondsEtc.

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Optimal search theoryStopping problemSample many times, choose bestFind your competitive advantage implies some

failureFail 90% of the time

Once you succeed and play again and againEducation is about finding what you are good

at, getting better at it, doing it again and againBad ‘rule’ for passive investing

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People apply a risk premium when there is zero alpha and they have to play super low risk assets have low returns (eg, cash)

AAA-BBB spread3 month to 1 year in Treasury Bill maturityEquity Risk Premium for efficient investors

No chance for alpha, because idiosyncratic volatility so low

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Geometric vs. Arithmetic Averaging 3.0% Survivorship Bias/Peso Problems 3.0% Post WW2 Reduct. in Eq. Premium 3.0% Taxes 2.0% Adverse Market Timing 2.0% Transaction Costs 2.0% Sum 15.0%

Most estimates around 3.5% for equity premium. With these additions, the Marginal Investor clearly could be seeing a 0% equity premium.

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Invariably backward lookingStrategies that have generated alpha

Convertible bond arbitragePairs tradingConvexity trade

Not super mathematical, but very detailed

Specific strategies with prospective alphaIndex investingBeta arbitrage

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Alpha is private information, valuableForce big ideas it down people’s throatsBe sensitive about revealing small ideas

Financial politics uses alpha as the key pretext

Someone paid $500k, $5MM, $50MM because they present alphaPolitics are not inversely proportional to the

stakes!

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Take risks finding your comparative advantageSample things, expect to pay to take such risks

Don’t take risk investing in above average volatility assets within any asset class, unless it’s a search for a comparative advantage

Don’t ‘risk adjust’ returns—Just like derivatives!

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