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,
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.
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.
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.
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.
*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" - http://en.wikipedia.org/wik...
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)?
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?
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.
I am glad that someone is finally talking about this idea.
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.