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The mythical risk premium

16-05-2012 | Research | Eric Falkenstein, Ph.D
The higher the risk, the more deluded the investors,” says Eric Falkenstein, PhD, quantitative investor and low-volatility expert. As a guest speaker at the Robeco 2012 Low-Volatility Investing seminar held in Rotterdam, he focused on the theory and evidence supporting the positive return from low-risk stocks.

Risk premium <=0 
As befits a financial expert, the title of Falkenstein’s talk was a formula, expressing that the risk premium is less than or equal to zero. Of course, this is in direct contrast to traditional investment  theory and the Capital Asset Pricing Model (CAPM), which expects that higher risk will produce more return. 

As Falkenstein describes it, “When the CAPM theory was created in the 1960s, the profession’s thought leaders pretty much assumed that the empirical corroboration would be easy…But the data have been very unkind, not just to their original model of risk and return (CAPM), but to any model purporting to capture the risk premium.” 

The backtracking from CAPM began in 1992. This was the year when Eugene F. Fama, respected academic and an early proponent of CAPM, documented a flat relationship between risk and return. In an interview with the New York Times when the research  was published, Fama admitted, “Beta as the sole variable explaining returns on stocks is dead.” Of course, there had been cracks in the CAPM before this, in particular, research by Dr. Robert Haugen, reporting a negative relationship between risk and return in US stocks, written in 1972 and published in 1975. 

100 years of data and no positive correlation 
It was the sign of things to come. Over the past decades, a mountain of evidence has accumulated regarding  lower-risk stocks producing better risk-adjusted returns than higher-risk stocks. One such study discussed by Falkenstein was research by Dimson, Marsh and Staunton (2005) analyzing more than a century of equity returns across 17 countries. 

The result? “No positive correlation is seen between returns and volatility or other measures of risk,” said Falkenstein. “Among country equity returns, there is no clear risk premium. The US had about the same average top-line return relative to short-term debt from 1900-2005 compared with 17 other countries worldwide, about 5%.” 

Equities just the tip of the iceberg 
Evidence of higher risk leading to better returns is absent from more markets than just equities. During his presentation, Falkenstein produced evidence of zero or negative returns from higher-risk investments across a range of financial markets including credits, private equity and currencies. He also cited other areas as diverse as IPOs, horse racing and lotteries. 

Falkenstein’s first book, “Finding alpha: the search for alpha when risk and return break down” was published in 2009 and delves into the theory and evidence supporting low-risk investing.  His latest book, “The missing risk premium” is illustrated with a unicorn. The mythical beast represents the imaginary positive relationship between risk and return.

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