Tuesday, June 16, 2009

My Book Finding Alpha

I got my complementary copies last week, and noted that after 3 months of not seeing the text, the typos seem to just jump off the page (eg, the index notes mention of "Einstein, Alfred"). My son said "you mean if you write a book, you get a copy for free?" "Yup". His eyes brighten, "that's awesome!"

I think I'm pretty harsh with the economic status quo, yet compared to most popular criticisms I'm pretty soft. On most issues I find myself having more in common with the works of the standard bearers of conventional theory than their critics. That is, I am less sympathetic to the behavioralist literature, or the 'economists are autistic idiots' crowd. The old phrase, 'the enemy of my enemy is my friend', may apply in war and politics, but not so much for ideas. This is only logical because if someone says x=3, and you say they are wrong, there are an infinite number of incorrect alternatives, and clearly as the status quo, the argument for x=3 is not bat-guano crazy.

You can see the 10-minute YouTube video below where I go over my argument (not the anecdotes). I have a whole collection of technical videos that complement my book over at /www.efalken.com/video (these are greater than 10 minutes, so can't be at YouTube), where you can download the powerpoints, and also with links to references. There are just to clarify those parts that are really technical. There's a technical version of my argument at the SSRN website here. The book is available today here at Amazon.

My book is the culmination of a 15-year journey that centers on a few key propositions, and the last third is on practical issues in finding alpha (e.g., the deception, the short-lived nature of strategies, the benefits of naive optimism). As much as my latter chapters really go over tangible strategies and practical stories, it is a niche book. My wife and sister both said it was over their heads, which implies that a smart person without a real financial interest may find this a bit too parochial.

Reading the Myth of the Rational Market, I noted that I highlighted many issues Fox mentions, I just focus more on the data and theory, as opposed to the personalities and anecdotes. That is, while popular books on Risk and Finance make you feel a lot closer to the personalities, who they disagree with, and the names of things they disagree upon, few of these books really get into what the key data are, and why you should believe a particular view, and why this is important. Indeed, in Myth of the Rational Markets you learn Eugene Fama and Dick Thaler strongly disagree as to whether markets should be called 'efficient'. But as their firms, Dimensional Fund Advisors and Fuller & Thaler, seem to offer the exact same strategies, it isn't clear why this matters.

Not that this is an extended academic journal article. There's a lot of personal stories and such in there, and I tried to make clear how the insights are not just true but useful. My companion article here at the SSRN website, goes over some of the data with much greater emphasis on my theory, with a lot more math and development of utility functions. I think someone interested in quantitative finance will see this as self-contained, but as my wife and sister noted, that may be optimistic on my part. Realistically, you probably need to have taken a corporate finance course to find this book intelligible.

To make an immodest plug for my book, I think it is a good read because it offers a consistent, new, important, and true argument. Very few books have all of these attributes.

Consistent: my basic argument is that risk, however measured, is not positively related to expected return. Further, that people tend to pay to take risk at the extreme, causing some assets to have a negative risk premium. Lastly, there is a slight risk premium on the low end of the risk spectrum, primarily as a cash premium.

New: I have yet to see elsewhere the basic idea, that risk in general does not and should not have an expected return premium in general (I note exceptions to this rule). This basically takes us back to pre-Markowitz, when no one presumed that risk explains the persistence of the equity return premium (and thus economic profits) in equilibrium.

Important: Risk, in terms of 'the risk that is priced', is everywhere in finance as an explanation. I'm asserting that, like in the Black-Scholes options model, you can ignore the risk premium and focus on the payoff space: magnitudes and probabilities. As Steve Ross has noted, if the standard model does not work it is actually more interesting, and useful, than if it did.

True: As I mention in the book, you can't test the general theory that risk is unrelated to return in general, because any test is merely a specific metric of risk, and it could be the metric that is flawed. In that way it is untestable. But I present a large survey of data in currencies, bonds, futures, equities, etc--over 20 asset classes--to suggest if risk is priced, it is very counterintuitive, which is implausible because presumably risk is priced because people generally agree on what it is.


Anonymous said...

fyi: when i go on defprob-publications and click on a link, i get the malware warning page. i'm on safari but they use google service so i guess it's on all browsers. methinks a 'friend' submitted the url as malicious. either that, or stop watching pron.

Eric Falkenstein said...

wow. There was an infected file in that directory. No damage generated. But thanks.

Frank said...

Congrats! A spelling note: here and on http://www.defprob.com/video/ you say that the videos compliment your book, but you mean "complement". I look forward to watching the the long intro and all the rest later.

Anonymous said...

Eric, your book is great. Who cares about typos. I found your 'honest' and real insights extremely refreshing and as someone who is paid (as you were/are) to generate alpha, It perfectly reflected my own journey from the academic simplicity of Barra-style factor models/styles/tilts to the realities of real risk and reward over the past few years. Don't mean to sound like a big suck up but you do good stuff - keep it up!

John said...

I'll probably purchase it, but 60 is a bit pricey. Makes it go lower on my list.

Web User Coruscation said...

When is the author tour ?

Note the used copies are already a $100+ collectors' item.


Plamen said...

Good luck, Eric. For me this will probably be a July 4th treat.

Anonymous said...

Amazon package tracking tells me your book shipped Sunday.

Anonymous said...

Great job. I look forward to reading your book. Having read the powerpoint slides and ssrn paper I forecast that the "economic status quo" will be harsher with you than with the behavioralists.

Anonymous said...

can't wait to read taleb's review on amazon. payback time!

But What do I Know? said...

Good luck with the book--I look forward to reading it.

talekhine said...

The videos look interesting to me, although as a layperson I don't know enough to evaluate your argument. Will we start seeing reviews of your book at some point? I can't find any on the web. (In a perfect world I'd like to see reviews by Tyler Cowen and the rest of the GMU people, Mankiw, Krugman, etc).

This reminds me: I'm somewhat surprised your blog is not more popular. To me your posts seem more insightful than those from much more famous economics bloggers. But as a layperson it may just be because I don't understand why you're wrong. Do you have a theory as to why your blog isn't more popular?