Eric Falkenstein’s *Finding Alpha*

The subtitle is The Search for Alpha When Risk and Return Break Down.  I definitely liked this book.  It's the best readable summary I know of why CAPM fails (see my comments here).  Market data do not, upon examination, show a close connection between risk and return, at least not once you start moving out on the risk spectrum beyond T-Bills and the like.  It's not just the famous Fama and French papers, it is worse than you think.  I also like the author's "relative status" theory for why many people enjoy risk; it reminds me of Reuven Brenner, a neglected economist to this day.

More controversially, Falkenstein believes the equity premium is zero or near zero.  I see it as positive but equilibration does not occur for at least two reasons.  First, people don't like the thought that they are losers, and second, their spouses can criticize their investment decisions when temporary nominal losses come and last for years.  In this sense my non-EFM view differs from his.

I recall someone in the blogosphere asking why this book does not overturn modern finance.  It is a very good book.  For it to "stick" it would need a clear empirical test of the relative status model of risk-taking vs. other models.  We don't yet have that and I am not sure we ever will.  There are too many conjectures consistent with Beta not much mattering for stock market returns and I am not sure the relative status model offers unique predictions within the realm of financial theory.  The relative status model offers plenty of testable, and often confirmed, predictions elsewhere, but once we drop EFM we're in a world where choice and risk are context-dependent and we still have to prove it is relative status-driven risk-taking which regulates equity returns.  That's very hard to do.

Here is one summary of the book.  Here is Eric Falkenstein's blog.