No Risk Premium?

Eric Falkenstein has posted here at Overcoming Bias five times; he now has a thoughtful blog and a new book:

Is the equity premium really zero? I think for the average investor, yes it is, and it’s a central issue in my book, Finding Alpha.

This paper gives his main idea, which is that there is no risk premium, i.e., an extra return for taking on more risky investments, because investors mainly care about relative wealth; if anything the highest risk investments get lower returns.  Eric complains he gets no respect:

I haven’t gotten a lot of public feedback on my book, but the private feedback is rather circular.  On one hand, there are those saying my findings are wrong. I’m ‘saying the earth is flat’, in one irate economist’s view. My empirical findings are not rigorous, in that I’m using incorrect statistical tests. … On the other side, I get comments like ‘this is obvious’, it’s ‘too simple’, or ‘everyone knows that’.

My asking around a bit confirms Eric; academic finance folks’ reaction is that everyone is sure there is a positive risk premium even though they admit the data isn’t very clear and everyone also knows relative wealth preferences exist and if strong enough could eliminate the risk premium.  My quick search didn’t find anyone else taking Eric’s strong position, and he says he can’t find anything either.

My best guess is that Eric is basically right.  In fact, I’d guess lower returns for the highest risk investments come from enough investors being risk-loving in relative wealth; they are willing to lose out on average for a chance to gain the very most.  However, even if Eric is eventually proven very clearly right, I’m not optimistic that he will get much credit or gain from it.

The folks more likely to be celebrated for this new discovery are prestigious academics with impressive related models or data analyses, even folks who would now say he is all wrong.  Eric knows his models and data analyses are rather simple, and he correctly notes they are good enough to make his main intellectual points.  But they are probably not difficult enough to make academics eager to affiliate with him, and so unless Eric can somehow get enough attention to shame academics into citing him, they won’t bother.

This sort of situation is exactly why I wanted to design better institutions like idea futures, where folks could be rewarded for backing a widely disbelieved view that is eventually vindicated.  But I admit it is not clear who really cares enough about truth to push for such change; backing the status quo is a better way to affiliate with credentialed as impressive folks.

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  • Selfishly, I wish Robin would explain how and why idea futures would be a better way for people to get reward and recognition than patents.

  • I am glad that someone is finally talking about this idea.

  • James K

    I wonder how much of risk aversion is actually loss aversion, in other words preference of the third moment of the returns distribution instead of the second. In fact, people might well be risk loving after adjusting for loss aversion. If nothing else, it would explain people who buy insurance and lottery tickets.

  • But they are probably not difficult enough to make academics eager to affiliate with him

    So why doesn’t he make another more difficult analysis for affiliation purposes?

  • Kevin Dick

    What about institutional investors, like pension funds, where the individuals making the investment decisions do not necessarily accrue the wealth corresponding to the decisions (at least not enough of the wealth to dramatically alter their relative wealth)?

  • *If* you could get better than average returns by taking risky investments, those providing secure investments would simply support their service behind the scenes by taking a spread of many risky investments.

    So: in a marketplace that is working properly, the *average* return on risky investments can be expected to be the same as on more secure ones. That is the real reason why “there has been no global equity premium over the 30-year period 1979–2009, as observed by Bloomberg” –

    • Jess RIedel

      You can only diversify to eliminate variance which isn’t correlated across the market.

  • So, you should be able to make an above average return by offering risky investments to investors who are looking for drama– it would be rather like running a casino– until all the slots for offering risky investments are filled, at which point you get an average return.

  • VennData

    With a 30%-plus rise in equities since the Bloomberg article in March ’09, hasn’t nearly one percent been added back to the ERP?

    What we saw then was a fluctuation, and now have a 1% EPR.

  • kebko

    Returns on quantifiable risk are going to be arbitraged away. I can understand that. But, investing in equities is an art & a science. Where risks aren’t easily quantified, the risk premium is large, but it’s really more of a skill premium.
    I don’t understand the tendency of economists to treat the financial markets as a special case. In every other field, we understand that markets, in perfect form, would eat away profits, but that inertia, location, unquantifiable competencies, etc. can allow some players & organizations to achieve higher than normal returns, and some fail due to poor competence, bad luck, etc.. It’s the same in finance. There are places where a risk premium is available, but it takes skill to capture it.

  • CJS

    I think he’s on to something, though I don’t know if it holds consistently across the spectrum. In the extreme case, this is why people buy lottery tickets.

    As for professional investors (hedge funds, mutual funds, etc.), I think they have different incentives. If they can hit a home run and differentiate themselves, they’re set; and if not, they’re not losing their own money.

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