Monday, September 06, 2010

Risk and Return in General

My theory is that life is like the purple chart, where risk premiums exist on Baa bonds, riding up 3 years on the yield curve, but that's it. After that risk is something we take with negative expected returns, because risky assets play into our overconfidence, signaling, and other outside-the-box needs. (regular chart is the conventional academic wisdom from Cam Harvey's website).
I've expanded by SSRN paper on risk and return, adding two new sections, and updating the empirical survey. I now have sections outlining the creation of the standard model, and the history of empirical testing, so it's now a 150 page beast (but skimming is encouraged!). Indeed, I put the paper into HTML and posted it up here, and you can skim around sections pretty easily there. When I put it into html the equations look kind of funny, but the pdf is pretty clear. I also have an updated set of references on asset pricing here.

As Greg Mankiw argues that students take economics in college, primarily finance, I think my paper is superior to the standard Corporate Finance course you will learn in college or graduate school. This is because they neglect to mention the fundamental theory that risk and expected return are positively correlated, is an empirical failure. Professors have been very successful at presenting the CAPM and its spawn as a triumph of the social sciences, in a way similar to how macroeconomists used to present Keynesian macro models before the Phillips curve started to do multiple backflips. The profs are filled with wishful thinking based on ever more obscure econometric tests that prove their big idea works, a science no less than thermodynamics. It doesn't work, not even as an approximation. You have a finite life, don't waste it on theories theories popular among professors but not practitioners. Plus, like Khan Academy, it's free.

9 comments:

Anonymous said...

Too late, already wasted my time on that theory.

Anonymous said...

You should prolly post it on repec too. More exposure that way.

Anonymous said...

Yes, but how good is your football team?

Slavko said...

Eric, have you read Robert Haugen's works? Wish to comment? Thanks

Eric Falkenstein said...

I have, and he's mentioned in my book and this paper. I note he too thinks 'risk' is often unrewarded, but he has an idea that stocks become out of line via the Lakonishok, Shliefer, and Vishny mechanism (extrapolating recent results), as opposed to a general patter, as he still believes in a risk premium. He basically believes people have several, if not dozens, of biases, that conflate the underlying risk-return forces that are operant.

So, in most cases we would agree on the implications, but some, not.

Caveat Bettor said...

just an edit, in Sec 2:

... and one choose to turn down a 50-50 bet to lose $10 or gain $11, ...

I believe 'choose' should be 'chose'.

Erik said...

Are you trying to say with your graph that very risky stock portfolios (like emerging market stocks?) have a long-term negative return? I have never seen any evidence for that. Or are you referring to short term potentially negative returns, or some other definition of "Highly Risky".

You can cherry pick stock indexes that are negative over 20 years, (Japan, etc.), but it is the exception to a rule that stocks provide decently positive, but volatile returns over the long haul - even the more risky ones.

I'm with you that low-vol stocks often have higher returns than high volatility stocks in some classes (say, US equities), but the same doesn't apply when comparing emerging market stocks with US stocks, at least over the last 30 years.

Eric Falkenstein said...

Erik: I wouldn't say risk countries have negative expected returns, I would just say they are very low. A country's portfolio vol is only 40% tops in risky countries over the cycle, so that's still less risky than the risky subset of US stocks.

See here for data underlying the assertion.

Anonymous said...

The general rule is that you won't be paid for any risk that can be arbitraged away. For example, you won't be paid for the risk of holding an individual stock, because a diversified portfolio of stocks can arbitrage away that risk. Thus the arithmetic average of stocks has a positive risk premium, but not individual stocks (or subsets of the market such as IPOs).