Risk and Return: Not So Easy

Eric Falkenstein is the author of Finding Alpha which argues that, in the real world, risk and return are not related. In fact, if there is a relationship, it’s probably negative. The more risk you take on, the worse you’ll do.
As Eric explains, a good example of this is in corporate bonds. Both the riskiest bonds—high-yield junk bonds—and the least risky—rock-solid AAA bonds—don’t do as well as bonds rated as investment grade but just below top-shelf.
Why is this? Is it that both ends of the risk spectrum unusually crowded? Eric writes:

It may be that individual investors expect high returns when investing in high risk assets, only that this is a mass delusion, the triumph of hope over experience. If so, that isn’t the ‘expected return’ one talks about in academic finance, that is, a statistically rational expected return. It is important to think of a return premium as due to two things: randomness and alpha. Randomness or luck we all understand. Alpha, however, is a little trickier. It isn’t something you can buy, because due to competition, no one sells it for less than cost, meaning, the insiders who structure and sell any alpha idea will take out all the extra return, leaving nothing at best, a mean-mode trade* at worst. To get alpha, you don’t buy something passively, you have to actively negotiate, time, or structure an investment, and while people can help you, no one will singularly present you with an extra-normal return. Further, most alpha attempts are like karaoke ballads, well intentioned but ultimately awful, meaning, after fees most alpha is negative (how else do so many alpha-less brokers afford their nice cars!?).
It is difficult to see how the little risk is priced, the big one not, if risk is to have any consistent meaning. If the corporate spread is a function of risk at one end, why is it not at the other, more intuitive end? This is but another reason I think there is no general risk premium, as explained in my series of Camtasia videos on my book here.

Posted by on May 11th, 2010 at 9:50 am


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