Merkel on Falkenstein's 'Finding Alpha: When Risk and Return Break Down'

I found Finding Alpha: When Risk and Return Break Down, by Eric Falkenstein, both easy and hard to review. Easy, because it adopts two of my biases: Modern portfolio theory doesn’t work, and the equity premium is near zero. Hard, because the book needed a better editor, and plods in the middle. I don’t ordinarily do this, but I felt the reviews at Amazon were valuable, particularly the most critical one, which still liked the book. I liked the book too, despite its weaknesses.

One core idea of the book is that risk is not rewarded on net. It doesn’t matter if you measure risk by standard deviation of returns, beta, or credit rating (with junk bonds). Junk underperforms investment grade bonds on average. Lower beta and standard deviation stocks overperform on average.

A second core idea is that some people are so risk averse that they only accept the safest investments, which leaves investment opportunities for those that are willing to compromise a little with credit quality or maturity. Moving from money markets to one year out is an almost riskless move for most, and usually adds a lot of excess return. Bond ladders do the same thing, though Falkenstein does not discuss those.

Also, the move from high investment grade to low investment grade does not involve a lot more investment risk, but it does offer more yield on a risk adjusted basis.

A third core idea is that equities, though more risky than high quality bonds, have not returned that much more than bonds when the returns are measured properly. (See an earlier post of mine for more details.)

A fourth core idea is that people are more willing to take risks to be wealthy than theory would admit. Most of those risks lose money on average, but people still pursue them.

A fifth core idea is that alpha is hard to define. Helpfully, Falkenstein defines alpha as comparative advantage. Focus on what you can do better than anyone else.

A sixth core idea is that leverage, however obtained, does not add alpha of itself. This should be obvious, but people like to try to hit home runs.

A seventh core idea is that when an alpha generation technique becomes well-known, it loses its potency.

An eighth core idea is that people are more envious than greedy; they care more about their relative position in this world than their absolute well-being.

One idea he could have developed more fully is that retail investors are easily deluded by yield. They underestimate the amount of yield needed to compensate for illiquidity, optionality, and default. Wall Street makes money out of jamming retail with yieldy investments that deliver capital losses.

Another idea he could have developed is that strategies that lose their potency lose investors, and tend to become less efficiently priced, leading to new opportunities. Investment ideas go in and out of fashion, leading to overshooting and washouts.

How one achieves alpha is not defined — Falkenstein leaves that blank, because there is no simple formula, and I respect him for that. He encourages readers to devise their own methods in areas where there is not a lot of competition. Alpha comes from being better than your competition.

Summary

What this all says to me is that investors are too hopeful. They look for the big wins and ignore smaller ways to make extra money. They swing for the fences and get an “out,” rather than blooping singles with some regularity. I like blooping singles with regularity.

I recommend this book for quantitative investors who can find a way to buy it for less than $40. The sticker price is $95, though it can be obtained for less than $60. Try to find a way to borrow the book, through interlibrary loan if necessary — that was how I read Margin of Safety by Seth Klarman. Klarman’s book is not worth $1000. Falkenstein’s book is not worth $95. Falkenstein’s very good blog will give you much of what you need to know for free, and even more than he has covered in his book.

This book would also be valuable for academics and asset allocators wedded to Modern Portfolio Theory and a large value for the equity premium, though some would snipe at aspects of the presentation. Parts of the book are more rigorous than others.

If you still want to buy the book at the non-discounted price, you can buy it here: Finding Alpha: The Search for Alpha When Risk and Return Break Down (Wiley Finance)

PS: Unless I state otherwise, I read the books cover-to-cover, unlike most book reviewers. The books are often different from what the PR flacks encourage reviewers to think. If you enter Amazon through my site and buy anything, I get a small commission.

Comments

[MarvinMBA:]

Portfolio Theory is a waste of time. I learned from studies and experiance the following:
Own only one or two stocks.
Understand these stocks in detail.
Hold as long as the stocks continue to meet you criteria for growth and protection. (Examples MSFT and INTC)
Hold Gold/Silver as these are going to be major performers over time.
Good Luck, MarvinMBA

Sep 05 11:40 AM

[The-Stock-M...:]

I tend to agree with MarvinMBA. If you own too many stocks, it's tough to keep track of them in all aspects. I've owned so many stocks over time, and realize that had I picked just one or two, like Cisco which is a solid company, I would've avoided all the risk, slept well at night and reaped some handsome gains. Some may say that my comments are of "hindsight is always 20-20" type, but in my 10+ years of investing and trading, I've come across so many people and situations myself, where a small selection of solid stocks always performed very well, than a large mix.
As far as risk-taking goes - the simple rule always holds good - risk only what you can afford to lose completely. For some, it maybe 100% of your portfolio, for some it maybe 1%, or anything in between. Always follow the percentage-rule with risk-taking and you will be very happy, and sleep very well at night!

Sep 05 12:42 PM

[Chandragupta:]

That's right, portfolio theory is crap! It is the surest way to get mediocre returns. What is risk? Risk is not beta, or standard deviation, risk is not knowing what you are doing! Know your investment well, and invest at the right price. That's the key to super normal returns - at low risk!

Sep 05 01:03 PM

[battman:]

I would agree as well except I would add that one could also look at a sector as much as an individual stock. Spread the risk over an entire sector you think has good growth potential. This lessens the likelihood of only owning Enron or Nortel or...you get my drift.


On Sep 05 12:42 PM The-Stock-Market-Crash... wrote:

> I tend to agree with MarvinMBA. If you own too many stocks, it's
> tough to keep track of them in all aspects. I've owned so many stocks
> over time, and realize that had I picked just one or two, like Cisco
> which is a solid company, I would've avoided all the risk, slept
> well at night and reaped some handsome gains. Some may say that my
> comments are of "hindsight is always 20-20" type, but in my 10+ years
> of investing and trading, I've come across so many people and situations
> myself, where a small selection of solid stocks always performed
> very well, than a large mix.
> As far as risk-taking goes - the simple rule always holds good -
> risk only what you can afford to lose completely. For some, it maybe
> 100% of your portfolio, for some it maybe 1%, or anything in between.
> Always follow the percentage-rule with risk-taking and you will be
> very happy, and sleep very well at night!

Sep 05 01:04 PM

[Michael Clark:]

Here all of us are seeking alpha....and you tell us that someone has already 'found alpha'.

Good review; very interesting.

Sep 05 01:17 PM

[enigmaman:]

Envision yourself on a cruise playing black jack, all players have their angle, their methodology, card counting, body language, etc, each player is playing to win that particular hand using their method, none worry about yesterdays play, or tomorrows only the game at hand is of importance, now throw into the mix, the ship is sinking, does anything change about how you play the game, you better believe it, because its no longer about that particular hand its about your life. Will you continue to play, do you stop, what do you do? Why do I bring this up, because we all look at the markets in the same way, instead of looking at the bigger picture. Zoom out away from that game, high above the ship, now you see more then you did at the table, now you see the world and you also see that your on the Titanic and you know its faith, considering the current state of the USA and the world, does anybody really believe that going forward its will be business as usual, who cares if this is really a true bull market rally or bear market trap if we are on a sinking ship. The market doesnt thrive on anything but short term news, corporations crash or fly based on their quarterly reports, what does it matter how many chips you have in your pocket if the ship goes down. Massive changes in the way Financials, energy, health care, auto industry do business is in our future, higher taxes, untenable debt, serious government interventions in all aspects of our lives and business. So forget about predicting the future by looking at the past, nobody knows what tomorrow brings and it appears nobody cares about anything but the game at hand. Nero fiddles as Rome burns

Sep 05 01:26 PM

[sixpackistan:]

big chief say you type much and say little.
pass the alpha.

On Sep 05 10:55 AM whidbey wrote:

> This is a chase that started some 100 years ago: pursuit of advantage,
> defined as "alpha". The concept of alpha itself may be just the
> phenomenology of hope. The hope being that there is some way to
> achieve an advantage over market return. It is considerable reservation
> that one believes alpha exists in fact. That said one can attempt
> to define alpha.
>
> The search commences in time, years in a series, many errors are
> based on the time series selected. Next, Analytic techniques are
> not "truth" per se, but " a point of view". In essence, one must
> be consistent in technique to avoid confusion (and learn anything)
> which is very difficult to do. Just since I got my doctorate the
> changes in financial theory have been voluminous, and dressed up
> with more mathematical statistics than are productive;( I think of
> them as chiefly makeweights to mundane theory). Finally, No one
> wants to appear to have lost, so much "touch-up" work is done in
> both the literature and the results of analysis.Technique Advocacy
> in is rarely criticized in Academia, nevertheless the advocates create
> cliques whose work is to further a theory/technique as the sole/best
> means of understanding a problem: modern portfolio theory is a prime
> example.
>
> Having read the book I found it pedantic, pedestrian, and narrow,
> but if one wants to see what is currently one the table, read it,
> but not too deeply please.

Sep 05 07:37 PM

[Dirtnap:]

An all-too-accurate analogy. Times ahead may be frightening and exciting.


On Sep 05 01:26 PM enigmaman wrote:

> Envision yourself on a cruise playing black jack, all players have
> their angle, their methodology, card counting, body language, etc,
> each player is playing to win that particular hand using their method,
> none worry about yesterdays play, or tomorrows only the game at hand
> is of importance, now throw into the mix, the ship is sinking, does
> anything change about how you play the game, you better believe it,
> because its no longer about that particular hand its about your life.
> Will you continue to play, do you stop, what do you do? Why do I
> bring this up, because we all look at the markets in the same way,
> instead of looking at the bigger picture. Zoom out away from that
> game, high above the ship, now you see more then you did at the table,
> now you see the world and you also see that your on the Titanic and
> you know its faith, considering the current state of the USA and
> the world, does anybody really believe that going forward its will
> be business as usual, who cares if this is really a true bull market
> rally or bear market trap if we are on a sinking ship. The market
> doesnt thrive on anything but short term news, corporations crash
> or fly based on their quarterly reports, what does it matter how
> many chips you have in your pocket if the ship goes down. Massive
> changes in the way Financials, energy, health care, auto industry
> do business is in our future, higher taxes, untenable debt, serious
> government interventions in all aspects of our lives and business.
> So forget about predicting the future by looking at the past, nobody
> knows what tomorrow brings and it appears nobody cares about anything
> but the game at hand. Nero fiddles as Rome burns

Sep 06 02:04 AM

[User 236735:]

Let's see ... David Merkel here, and Harry Markowitz and William Sharpe there ... real tough decision. Who the hell is David Merkel, some clown trying to make money out of hard times, and that's not new either. Come up with a proper economic refutation of modern portfolio theory, and I'll listen. This crap, no way!

Sep 06 10:45 AM

[Old Trader:]

User 236735,

David is one of the more thoughtful contributors to SA (and no, I have no personal knowledge/connection with him), and he's only offering up a review of this particular book, and his personal view on some of the key points, and an overall opinion. I think your judgement of him is unduly harsh.

David,

I find your reviews very helpful when deciding on how to spend my hard-earned dollars in expanding my library of financial literature.


On Sep 06 10:45 AM User 236735 wrote:

> Let's see ... David Merkel here, and Harry Markowitz and William
> Sharpe there ... real tough decision. Who the hell is David Merkel,
> some clown trying to make money out of hard times, and that's not
> new either. Come up with a proper economic refutation of modern portfolio
> theory, and I'll listen. This crap, no way!

Sep 06 01:11 PM

[Alphameister:]

I continue to find modern portfolio theory a very useful tool in my investment and trading, even though my best-performing stocks are always sold at computed alphas well above the levels at which I acquired the stocks. I use an approach very much along the lines of Jim Shaughnessy's "What Works on Wall Street" except that I prefer alpha as my measure of relative strength. As a trader, I try to use volatility to my benefit, trimming high-alpha positions that have surged too far above trend and buying them back as they pull back to technical support. I can understand the author's conclusion that risk is not rewarded, but it all depends on one's definition of risk. I regularly buy stocks that many would dismiss as risky "junk" based on relatively small market caps despite the fact that the "junk" I buy tends to have stellar balance sheets, strong measures of profitability, and low valuation ratios. Risk, like beauty, is in the eye of the beholder and I'm grateful that an unenlightened aversion to risk (as commonly perceived) creates a relatively inefficient market that I am able to exploit to great advantage.

Sep 06 01:15 PM

[Alphameister:]

As an addendum to the above, I tend to favor stocks that offer both high alphas and low betas, though I'm more willing to hold higher-beta stocks when I'm optimistic about the market's outlook.

Sep 06 01:23 PM

[Kevin Hollins:]

A very thoughtful review; thanks for sharing.

Sep 06 01:35 PM

[Moon Kil Woong:]

Haha, Goldman Sacs found alpha in making the spreads you have to pay. Especially when their HFT makes it impossible for you to see real bids and asks and they buy all the real orders through flash programs and dark pools so you don't even know about them. Smart, devious, and great at undermining the market. Machavelli would be proud.

For us, finding Alpha just got tougher now that we are paying a cut of all bets to the house.

Sep 06 11:59 PM

[user1010101:]

Although I agree that his review was overly harsh - he makes a good point. Portfolio Theory is an economic "idea" just like all economic models. Like all things in economic theory, it can not be proved. Most likely, poor performance brought upon by the use of modern portfolio theory is the result of improper adherence to the theory. (***Please note, anyone who disagrees with me regarding what I have said above should really try reading the papers presented by Markowitz, Modigliani, Miller, Sharpe, Lintner and Mossin - along with achademic commentary. Achademics understand that theories rely on ideas regarding ex-ante expectations whereby we only test the theory assuming ex-post data is an unbiased predictor. Basically, I am trying to tell people to do there homework before thinking they understand any of these ideas that have been presented).

Being a good stock picker is a skill whereby "alpha" can be achieved. However, this is not a skill that everyone has or can learn! I would like to reference Nassim Talebs argument which based reflects the reason MPT is very much a useful tool where as stock picking is highly risky -> if the downside essentially takes you out of the game, it is too big a risk regardless of how much upside you may achieve.

Essentially, owning only 1, 2, 3 stocks puts you at a very high risk. Even if the risk is so small (i.e. a bomb could be dropped on the company eliminating everything) the risk is too big to take. Diversifying an using methods such as those implied by MPT should not be overlooked or talked down upon.


On Sep 06 01:11 PM Old Trader wrote:

> User 236735,
>
> David is one of the more thoughtful contributors to SA (and no, I
> have no personal knowledge/connection with him), and he's only offering
> up a review of this particular book, and his personal view on some
> of the key points, and an overall opinion. I think your judgement
> of him is unduly harsh.
>
> David,
>
> I find your reviews very helpful when deciding on how to spend my
> hard-earned dollars in expanding my library of financial literature.
>

Sep 07 03:38 PM

[Foolsaeon:]

For me I think the most important varialbe for investing is the dow/gold ratio. This is a nice long cycle that fluctuates between 40 and 1. What this ratio shows is when it is time to move from stocks into real assets like gold and when to move from gold into stocks.
What is not often talked about, especially in the mainstream media is the fact that real return is the only thing that counts at the end. To give an extreme example. If you invest in the S&P and you have a 50% profit but the currency you were investing in loses 100% in value (in relation to assets, and commodities, that people are surrounded by) over the same period, the investment was not great.

If you have this overall trend correct you will be doing well in the long term.
Currently, we are moving from a dow/gold ration of 42 towards 1. People are debating if we are in a deflationary or inflationary environment. Looking at this ration and believing in this ratio going back to 1, it does not really matter what the outcome will be long term. We could see the down at 1000 and gold at a 1000 at the same time, or we could see the dow at 20000 and gold at 20000. Important is that you achieve the best real return. What does it help you holding S&P shares, the S&P being at 20000 but the currency you are holding the shares in being worthless!!!!! Being a millionaire in Zimbabwe is not a great accomplishment!

Its just a thought. Good look trading these uncertain and volatile markets in the future!


On Sep 05 01:26 PM enigmaman wrote:

> Envision yourself on a cruise playing black jack, all players have
> their angle, their methodology, card counting, body language, etc,
> each player is playing to win that particular hand using their method,
> none worry about yesterdays play, or tomorrows only the game at hand
> is of importance, now throw into the mix, the ship is sinking, does
> anything change about how you play the game, you better believe it,
> because its no longer about that particular hand its about your life.
> Will you continue to play, do you stop, what do you do? Why do I
> bring this up, because we all look at the markets in the same way,
> instead of looking at the bigger picture. Zoom out away from that
> game, high above the ship, now you see more then you did at the table,
> now you see the world and you also see that your on the Titanic and
> you know its faith, considering the current state of the USA and
> the world, does anybody really believe that going forward its will
> be business as usual, who cares if this is really a true bull market
> rally or bear market trap if we are on a sinking ship. The market
> doesnt thrive on anything but short term news, corporations crash
> or fly based on their quarterly reports, what does it matter how
> many chips you have in your pocket if the ship goes down. Massive
> changes in the way Financials, energy, health care, auto industry
> do business is in our future, higher taxes, untenable debt, serious
> government interventions in all aspects of our lives and business.
> So forget about predicting the future by looking at the past, nobody
> knows what tomorrow brings and it appears nobody cares about anything
> but the game at hand. Nero fiddles as Rome burns

Sep 07 05:10 PM

[Living4Divi...:]

Enigmaman -

Suppose what you said was completely true, then it would mean that bonds, stocks and real estate are all bad investments.

So what is a good investment, in your opinion?

Or is that the crux of your enigma?

On Sep 05 01:26 PM enigmaman wrote:

> Envision yourself on a cruise playing black jack, all players have
> their angle, their methodology, card counting, body language, etc,
> each player is playing to win that particular hand using their method,
> none worry about yesterdays play, or tomorrows only the game at hand
> is of importance, now throw into the mix, the ship is sinking, does
> anything change about how you play the game, you better believe it,
> because its no longer about that particular hand its about your life.
> Will you continue to play, do you stop, what do you do? Why do I
> bring this up, because we all look at the markets in the same way,
> instead of looking at the bigger picture. Zoom out away from that
> game, high above the ship, now you see more then you did at the table,
> now you see the world and you also see that your on the Titanic and
> you know its faith, considering the current state of the USA and
> the world, does anybody really believe that going forward its will
> be business as usual, who cares if this is really a true bull market
> rally or bear market trap if we are on a sinking ship. The market
> doesnt thrive on anything but short term news, corporations crash
> or fly based on their quarterly reports, what does it matter how
> many chips you have in your pocket if the ship goes down. Massive
> changes in the way Financials, energy, health care, auto industry
> do business is in our future, higher taxes, untenable debt, serious
> government interventions in all aspects of our lives and business.
> So forget about predicting the future by looking at the past, nobody
> knows what tomorrow brings and it appears nobody cares about anything
> but the game at hand. Nero fiddles as Rome burns

Sep 07 10:21 PM

[Graham and ...:]

Dear L4D:

This instablog post explains how only gold is a good investment during the current (fourth) "turning." Stocks, bonds, and real estate are all relatively poor performers.

seekingalpha.com/insta...


On Sep 07 10:21 PM Living4Dividends wrote:

> Enigmaman -
>
> Suppose what you said was completely true, then it would mean that
> bonds, stocks and real estate are all bad investments.
>
> So what is a good investment, in your opinion?
>
> Or is that the crux of your enigma?
>
> On Sep 05 01:26 PM enigmaman wrote:

Sep 08 02:37 PM

[Living4Divi...:]

Thanks G & D - I kinda figured that was the answer - but was asking the question to see what Enigmaman's answer was.
I guess he is onto other things and not following this thread.


On Sep 08 02:37 PM Graham and Dodd Investor wrote:

> Dear L4D:
>
> This instablog post explains how only gold is a good investment during
> the current (fourth) "turning." Stocks, bonds, and real estate are
> all relatively poor performers.
>
> seekingalpha.com/insta...
>

Sep 09 02:00 PM

[Living4Divi...:]

Still waiting for Enigmaman's reply


On Sep 09 02:00 PM Living4Dividends wrote:

> Thanks G & D - I kinda figured that was the answer - but was
> asking the question to see what Enigmaman's answer was.
> I guess he is onto other things and not following this thread.<br/>

Sep 10 11:53 AM