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.

Comments

>>Market data do not, upon examination, show a close connection between risk and return ... It's not just the famous Fama and French papers. >>
There should not be a close connection between risk and return. If risk were always rewarded, it would not be risk. Theory says there should be a close connection between risk and expected return.

Fama French said that there is a close connection between risk and expected return, but that CAPM is not a good model. They say one should look at beta plus a size factor and a value factor. With the better model, the risk/expected return relation is there.

I haven't read the book, but it sounds like Falkenstein's theory suffers from the same problem (from a scientific, rather than philosophical, perspective) as Intelligent Design theories suffer in biology: they just don't offer readily falsifiable empirical claims that can distinguish these theories from more conventional ones. It sounds like an interesting story, but I wouldn't call either scientific.

There's too much "alpha" in the discourse. Cronbach's alpha, social choice theory alpha, alpha male... way too confusing when it shows up in a book title. I seriously had an aversive reaction to it.

Falkenstein is an ID'er. From what he writes on his blog it appears that he believes he is a world class expert on evolution, and apparently a variety of other scientific areas as well.

The concept of the "blog" has turned out to be the greatest human invention so far for injecting multidimensional transparency into discussions. One curiosity (to me) is that it seems to be very difficult, so that it is extremely rare, perhaps even impossible, to acquire a high degree of reliability across multiple disciplines.

Surely the burden of proof should be on theories that propose an excess return from investing in risky assets: as you note, the data is not very supportive of such theories.

> 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.

That is the real substance of his argument - the evidence is not strong for an excess return from risky assets, in general. Why should the burden of proof be with Falkenstein to prove the relative status model?

> For it to "stick" it would need a clear empirical test of the relative status model of risk-taking vs. other models.

Perhaps this next point gets at the real issue: Falkenstein goes against the conventional wisdom, a wisdom which may be disconnected from empirical facts.

>More controversially, Falkenstein believes the equity premium is zero or near zero.

Hey Tyler, thanks for linking to my review! :)

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