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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 manager
www.defprob.com
www.efalken.com
falkenblog.blogspot.com
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TA for Hyman Minsky in 1986
Risk essence of interesting
economics, undefinable
1994 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 prices
Consumption growth
Per-capita labor income
Consumption/wealth ratio
Statistical (latent) Factors
Etc.
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"Risk is not an add-on … it permeates the whole body
of thought.“
Robert C. Merton
“most returns and price variation come
from variation in risk premia”
John Campbell
FV
PV
1 r g
g PV
g PV
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Finance is “the only part of economics that works”
Andy Lo
Derivatives: risk neutral
expected value
Efficient Markets: hard to
make money
finance > economics > sociology
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‘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 Campbell
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75 % of finance professors would recommend using the
CAPM for capital budgeting,
10 % the Fama-French model,
Ivo
5 % some unspecified APT
Welch
Why use it?
1) CAPM ‘works’ if we ignore small firm effect
2) Everyone (ie, academic finance) does it
3) What else should we do?
4) Intuitive (it should work)
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Risk aversion like aversion to smelliness
Is mathematically consistent
Given assumptions, asset pricing theory is correct
CAPM special case of APT and SDF theory
Like physics: mathematical beauty leads to truth
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Leveraged Firms
B vs. BBB rated Bonds
Out-of-the-money options vs. at-the-money options
S and C corps vs. equity indexes
Highest volatility vs. modest vol stocks
R rated movies vs. G rated movies
Lotto vs. ‘quick pick’ lotteries
50-1 horses vs. 3-1 horses
Mutual funds, currencies, futures, countries, yield
curve
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Low vol
Low beta
Profitable
Unlevered
High vol
High beta
Unprofitable
levered
“Safe?”
“Risky?”
“Beautiful?”
Nobody charges differently for capital within a bank
Mortgages
real estate
credit cards
Hedge fund: funding rates the same for
distressed lending
Convertible bonds
pairs
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Relative Utility no general risk premium
Instead 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 returns
Lottery returns
high vol stocks
Junk bonds
Etc.
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Optimal search theory
Stopping problem
Sample many times, choose best
Find your competitive advantage implies some failure
Fail 90% of the time
Once you succeed and play again and again
Education is about finding what you are good at,
getting better at it, doing it again and again
Bad ‘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 spread
3 month to 1 year in Treasury Bill maturity
Equity Risk Premium for efficient investors
No chance for alpha, because idiosyncratic volatility so low
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Geometric vs. Arithmetic Averaging
Survivorship Bias/Peso Problems
Post WW2 Reduct. in Eq. Premium
Taxes
Adverse Market Timing
Transaction Costs
Sum
3.0%
3.0%
3.0%
2.0%
2.0%
2.0%
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 looking
Strategies that have generated alpha
Convertible bond arbitrage
Pairs trading
Convexity trade
Not super mathematical, but very detailed
Specific strategies with prospective alpha
Index investing
Beta arbitrage
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Alpha is private information, valuable
Force big ideas it down people’s throats
Be sensitive about revealing small ideas
Financial politics uses alpha as the key pretext
Someone paid $500k, $5MM, $50MM because they
present alpha
Politics are not inversely proportional to the stakes!
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Take risks finding your comparative advantage
Sample 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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