The Missing Risk Premium

Imagine if there was a well-established scientific principle that was taught in schools, had won Nobel Prizes and was accepted across-the-board by experts, yet it was completely and totally wrong.

While this may sound far-fetched, this is the basis of Eric Falkenstein’s new book, “The Missing Risk Premium,” and he makes a convincing case.

Instead of science, Falkenstein looks at economics and argues that the “risk premium,” the reward for investors who shoulder risk, does not exist. This isn’t small potatoes he’s taking on. The risk premium stands front and center in the world of financial economics, and Falkenstein shows us that there’s very little empirical evidence it even exists.

We’ve long known that stocks have beaten bonds over the long run. So academics attempted a model to explain this fact. Their model says that the reason why stocks have beaten bonds is due to risk. Of course, they’re just slapping the name “risk” on to something better described as “that which we do not know.” It’s like calling a black hole “Cleveland.”

The model further states that risk can be quantified and the more of it you take, the better you’ll do. So one would expect that stocks with higher risk should do better than stocks with lower risk. But that’s not the case at all. In fact, stocks with the highest risk do the worst, and stocks with the lowest do the best (Falkenstein is a proponent of minimum volatility investing.)

Just because the measurement of risk explains the gap between stocks and bonds, when applied to individual stocks, it says nothing. Falkenstein goes beyond the world of stocks and looks at several areas where there’s no payoff in taking more risk, or the payoff is actually negative.

I think the example of horse racing probably explains this best. Researchers have found that betting on the long-shot has had the worst payoff. My guess is that in any given race, the long-shot will draw interest from bettors who simply want to bet on the long-shot, no matter how good the horse really is. Betting and winning on the favorite may offer a higher payout (losing money somewhat slower), but it’s not as much fun at hitting the rare long shot. This is what probably draws many investors to obviously overpriced risky stocks. They simply want to be in the game, and they’re willing to ignore the numbers. The lottery is the same way.

What caught my attention is that one of the few areas where a risk premium does appear to exist is at the short end of the yield curve. My guess is that what’s happening is that the characteristic of the asset takes on an over-sized image in the mind of investors. As a result, they’ll over pay for a long shot simply because it’s the long shot. Or they’ll overpay for a risk-free asset simply because it’s risk free. This only works at the extreme and going half way won’t get you half the results.

Some of these concepts Falkenstein covered in his first book, Finding Alpha. This book, however, is much shorter and less technical. Regular readers of his blog (Falkenblog) will also surely recognize many of these arguments.

One of the most eye-raising aspects of the book is where Falkenstein discusses the many small losses that individual investors suffer between the stock gains they see reported on CNBC, and the returns they get. Investors are constantly dinged by things like bad timing, transactional costs, bid-ask spreads and taxes. Once you throw in variables like survivorship bias, Falkenstein says that the historical databases we have return bare little resemblance to what made its way towards investors’ pockets. This topic alone could serve as a useful book.

Falkenstein does say, and I’m inclined to agree, that a risk premium exists between stocks and bonds exists but only for the highly-efficient investor. My guess is that the equity risk premium is probably between 1% and 2% which is far less than what’s accepted by many economists.

Falkstein’s meta-thesis is that investors aren’t greedy; they’re envious. In other words, they don’t simply want the most they can get. They want more than their neighbors. Once you adopt this frame of reference, it undermines the idea that greater wealth can be purchased with greater risk.

My only criticism of The Missing Risk Premium is that this is a self-published book, and the editing is somewhat sloppy. Also, some language explaining difficult concepts is unnecessarily convoluted. Still, the argument presented is strong and clear and will hopefully convince the world that better returns aren’t paid for with pain.

Posted by on September 17th, 2012 at 11:17 am


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.