THE MISSING RISK PREMIUM

In this contrarian view of the asset pricing model, Falkenstein attempts to debunk the notion that greater risk equals greater reward.

In this detailed statistical study of risk as it applies to financial investments, the author claims that most in the financial world agree with the theory that “the expected return of a financial asset is a function of risk.” However, Falkenstein, who holds a Ph.D. in economics from Northwestern University and has been a risk manager and portfolio manager, contends that there is little evidence supporting the idea that taking risk results in higher returns. In fact, “in practice any measure of risk is at best uncorrelated with average returns and is often negative.” The author, targeting economists, financial analysts and students, expounds on the current asset pricing theory, discusses the “rise and fall of standard models,” and for good measure, adds a bit of psychosocial commentary in chapters entitled “Why Envy Explains More than Greed” and “Why We Take Too Much Financial Risk.” Falkenstein’s perspective is that asset pricing theory “is based on a profound mistake over what is more important to financial decision makers, envy versus greed.” He advocates “the acceptance of what predicts better, and the rejection of what predicts worse.” As evidence that it’s difficult to swim against the tide, the author cites his own experience trying to convince others to buy low-volatility stocks. He writes that his idea “was always dismissed” until he became an equity long-short portfolio manager at a hedge fund, where, he asserts, he personally made $3.5 million over two years. The author’s conclusion is likely to be controversial in some circles, if not downright inflammatory: “Many common investment strategies and tactics are as costly as gambling.”

While the book’s reliance on statistical analysis may make it too technical for the average reader, it’s likely to be an eye-opener for economists and financial analysts willing to consider unconventional alternatives.