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Finding Alpha: The Search for Alpha When Risk and Return Break Down Relié – 10 juillet 2009
An innovative guide to finding alpha in a world where risk usually does not correlate with higher returns
Finding Alpha is a practical guide to achieving alpha when conventional measures of risk rarely correlate with higher returns. To start, author Eric Falkenstein a PhD who has also been a risk manager and portfolio manager walks readers through the Capital Asset Pricing Model (CAPM), as well as other well–documented theories about risk and return, and explores how these theories measure up to current empirical evidence being documented by researchers and academics. Rounding out the discussion, Falkenstein outlines prominent real examples of alpha in finance, and how the search for alpha affects the day–to–day life of all finance professionals.
Eric Falkenstein, PhD (Eden Prairie, MN), developed RiskCalc TM, the world′s leading scoring tool for evaluating private firm default risk, while at Moody′s Risk Management Services.
- Nombre de pages de l'édition imprimée298 pages
- LangueAnglais
- ÉditeurJohn Wiley & Sons
- Date de publication10 juillet 2009
- Dimensions16 x 2.64 x 23.62 cm
- ISBN-100470445904
- ISBN-13978-0470445907
Description du produit
Quatrième de couverture
"Eric Falkenstein is more than one of the smartest and funniest people in finance. He′s been a banker, a key model builder at a major rating agency, and a hedge fund trader. In this tour de force, he outlines the successes and failures of financial theory applications in the real world from the perspective of an aggressive early adopter of the best ideas in finance. To this day, I think Eric′s private firm default model is one of the best papers ever published in applied finance, and this wonderful book falls into the same category."
Donald R. van Deventer, PhD, founder and Chief Executive Officer, Kamakura Corporation
"People dismissed Columbus when he said the world was round. Thank goodness he persisted. Like Columbus, Falkenstein challenges standard thinking, only this time about risk and reward. As the meltdown of the capital markets has shown, the financial industry clearly missed something with regard to risk management. As an industry, we need to consider alternative theories on risk, and clearly Falkenstein is on to something here. Agree with him or not, Finding Alpha is worth a read."
Kevin M. Blakely, President and CEO,The Risk Management Association
"Writing through the lens of an experienced practitioner, Falkenstein digests decades of research in capital markets, financial economics, and investment psychology that have shaped modern investment theory. This text is an excellent companion for portfolio managers, investment students, or anyone seeking to better understand the relationship between risk, returns, and financial reward."
Todd Houge, PhD, CFA, The University of Iowa
How do we find alpha whenrisk does not correlate with return?
Finding Alpha is a practical guide to achieving alpha when conventional measures of risk rarely correlate with higher returns. Author Eric Falkenstein–a PhD who has also been a risk manager and portfolio manager tells the story of alpha from its beginnings to its current reversal, where risk is now evidenced by return as opposed to vice versa.
Falkenstein begins by walking readers through the Capital Asset Pricing Model (CAPM), as well as other well–documented theories about risk and return, and explores how these theories measure up to current empirical evidence being documented by researchers and academics. He also outlines a novel approach to the issues of how benchmark risk and investor overconfidence affects expected asset returns, how to understand the nature of alpha and risk, and how to use practical applications of alpha–seeking strategies that he developed as a successful hedge fund manager.
Finding Alpha concludes by outlining some real–life applications of alpha in finance and explains how the search for alpha affects the day–to–day life of all financial professionals.
Biographie de l'auteur
Détails sur le produit
- Éditeur : John Wiley & Sons; 1er édition (10 juillet 2009)
- Langue : Anglais
- Relié : 298 pages
- ISBN-10 : 0470445904
- ISBN-13 : 978-0470445907
- Poids de l'article : 496 g
- Dimensions : 16 x 2.64 x 23.62 cm
- Commentaires client :
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Falkenstein reaches four basic conclusions:
For most assets, the rate of return is unrelated to its volatility.
Really safe assets have below average returns
Really volatile assets have below average returns
Investors are overconfident, creating excess costs and position concentration.
He argues that this is because:
People are more envious than greedy (i.e. they are more concerned with their position relative to others than in their own absolute wealth.)
People are willing to accept risks in return for the hope (often unfounded) of outsized gains, in investing and other aspects of life.
People save some money in supersafe assets to avoid the chance of losing everything.
Chapter 1 asserts that the common belief that risk begets return (as assumed by most economists and the CAPM) is wrong. He argues that "risk tolerance [in financial markets] is not like physical courage, the ability to withstand a physical pain, but rather like intellectual courage, the ability to withstand ridicule. He argues that finance needs a paradigm shift from CAPM, which doesn't even approximately fit the data, but which dominates the conceptual frameworks of academia and finance practitioners.
Chapter 2 presents the history and derivation of CAPM and later generalizations such as APT, and points out that all share the same basic assumptions about risk aversion.
Chapter 3 presents the history of how academics have bolted, (like Ptolemy) "epicycles" on to CAPM, to explain why it fails to explain the data. For example, why do lower beta stocks outperform high beta stocks (controlling for size), when CAPM's key conclusion is that the opposite will occur?
Chapter 4 provides numerous examples of how higher risks within and between asset classes have not yielded higher historical returns. Most of these examples are within rather than across asset classes. For example, higher leverage stocks underperforming lower leverage companies, the inability of beta to explain fund returns, junk bonds underperforming investment grade bonds, gambling long-shots underperforming favorites, 20 year bonds underperforming 10 year bonds.
Chapter 5 presents data on the behavior of investors that conflicts with the assumptions of CAPM and MPT. The author argues that the underlying utility function (diminishing marginal utility of absolute wealth) employed by economists to explain risk premiums are to blame, and steers the reader to research suggesting that happiness is related to relative status rather than absolute levels of wealth.
Chapter 6 asks "Is the equity risk premium zero?"
The author answers that after adjusting for the use of algebraic returns, survivorship bias, the possibility of large losses, one-time valuation-expansion benefits, tax effects, and transaction costs, a retail investor probably doesn't earn higher returns from equities than risk-free investments.
I think this chapter is a bit weak in that the equity risk premium is a question about the asset class, rather than the typical practice of retail investors. It is worth considering the equity risk premium as a theoretical rather than a practical premium, which can easily be lost to unwise practices. The evidence in the book against within-asset-class risk-return relationships appears to be stronger than across-asset-class risk-return inversion (i.e. that cash would outperform bonds, and bonds would outperform equities). Nevertheless, there is a reasonable argument to be made that that even for fairly long time horizons, one should not assume that historic risk premiums achieved by equities will hold for a given country, and that practitioners should instead make a fundamental assessment of likely future returns.
Chapter 7 checks back in with the CAPM, and notes that despite all of the data and investor behaviors at odds with it, the model is still taught, its assumptions are assumed, and its thought leaders are still given prizes, primarily because the model appeals to philosophically Rationalist (not rational) intellectuals.
Chapter 8 argues that relative utility, rather than diminishing absolute utility, is what people really act upon. A simple example, as well as formulas, are provided to illustrate why investors acting to minimize the variance of relative wealth, (i.e. are more concerned with keeping up with "the Joneses", or the benchmark), creates a condition of no risk premium.
Chapter 9 presents an anthropological explanation of why humans are "inveterate benchmarkers," bringing in Darwinian factors to explain the existence of envy and power-lust, and game theory to justify "reciprocal altruism" (essentially repeated cooperation). The author bizarrely argues that "Envy is necessary for compassion in a developed economy" because one's understanding of a fellow citizen's envy allows one to empathize with their feelings. The chapter's conclusion is less than clear to me, but seems to conclude that while people should be greedy (i.e. pursuing their rational self-interest) if their goal is to maximize absolute wealth, in reality, most people are envious, and working to maximize their status.
In this chapter, the author would have benefitted from exploring the ideas of Ayn Rand on egoism and rational self interest, as well as her psychological exploration of "second handers" in her novel "The Fountainhead." In particular, Ayn Rand illustrates why thinking independently while focusing on one's absolute (not relative) wealth is in one's rational self interest. This is, ultimately, what the author suggests that an investor should do in the pursuit of alpha, but doesn't explain why an individual should value additional wealth over, say, conformity, or trend-following, or the "comfort" of following the herd.
Ultimately, the key thesis of the book rests on the assumption that investors act much like Peter Keating, the leading "second hander" in Ayn Rand's "The Fountainhead," and seek conformity, safety in numbers, and focus more on what others do, think, and own.
Chapter 10 presents the book's general framework of four conclusions, and focuses in this chapter on the idea that risky investments are driven by hope, driving investors towards behaviors more like gambling than return maximization.
Chapter 11 provides some examples of alpha-generating activities, and how they fade over time. Convertible bond "arbitrage," index funds, automated credit scoring, and floor traders are featured. These alpha strategies are really just applications of competitive advantage to finance.
Chapter 12, titled "Alpha Games" goes into the behavior of people, institutions, and investors to acquire, maintain, and divide alpha.
Chapter 13 provides several real-life alpha-creating applications from the author, including minimum variance portfolios, beta arbitrage portfolios, bond investment strategies. These are all fairly simple applications that have delivered superior risk adjusted returns and are consistent with the theoretical assumptions provided by the author. These strategies are mostly institutional-level, and thus not likely implementable for retail investors, yet would not be particularly difficult to implement for institutions. He ends the chapter with some motivational words, encouraging the reader to pursue their efforts to find their signature strengths, employ them to create alpha, and maximize their income and career satisfaction.
Chapter 14 summarizes the book.
Falkenstein's book is likely to strike a chord with experienced investment professionals who think independently, and have seen with their own eyes the many divergences of markets from the scholarly models that dominate the profession. Because his model better fits the historical facts, better matches observations of many investors' behavior, and is reasonably simple, it provides a better approximation of how investment markets function than that of certain Nobel Prize winners.
The book is not perfect. The focus of the book is more about "why risk and return aren't related" than about "finding alpha." Alpha, after all, is a concept borrowed from a theory the author demonstrated to be false. While many ideas are integrated into a comprehensible structure, the framework still seems somewhat ad-hoc. And I am not so pessimistic about investors as to believe that all people are always driven by relative utility. That behavior surely exists, but is far from the only element driving markets, or investors. But it seems a good enough explanation for part of the unexpected deviations of actual practice from standard finance theory.
This book is a good follow up to another good book that had an influence on my professional life, Robert Haugen's "The New Finance", which also demonstrated the failure of beta to explain returns, and provided a mostly institutional explanation for why this might be, including groupthink, benchmark-following, and career-risk aversion.
Falkenstein's book reinforces my view that irrationality and a lack of independent thought are major value destroyers - in investing and in life. This book prepares one to make the rational choice, gather one's intellectual courage, abandon envy (and benchmarks), and instead embrace greed in investing.