Have you stress-tested your fundamental investment assumptions recently?

In the midst of the economic and financial crisis this was a great deal of discussion on the “lost decade for stocks.”  Returns showed the broad stock market underperforming bonds and even CDs over decade-long time periods.  In short, it was fashionable to trash stocks.

Now that the crisis has seemingly abated the pressure is seemingly off to make hasty portfolio changes.  Therefore it may be time to re-visit this topic (and others) from another perspective.

For instance, what if after taxes and other costs the equity risk premium (ERP) were indistinguishable from zero?

Or what if the relationship between risk and return is not positive, but risk and return were largely uncorrelated?

For most investors, and investment professionals adopting these insights would fundamentally change the way you go about investing.

Eric Falkenstein at Falkenblog has made these assertions in his blog and in his book.  The entirety of the argument is beyond the scope of a blog post.  However he argues that since we are interested in relative wealth, risk is in fact deviations from the market portfolio.  Therefore all risk is idiosyncratic and therefore unpriced.

His argument is making a few waves in the investment community with what, are to some, radical thoughts on the fundamental building blocks of investment management.  For instance you can read Erik in a debate with Justin Fox on the Efficient Markets Hypothesis at CBS Moneywatch.  His work has also appeared at Clusterstock on topics including high frequency trading.  We have also linked to a few of his blog posts as well.

The question is to what degree this hypothesis will gain adherents. Robin Hanson at Overcoming Bias largely agrees with the Falkenstein’s notions, but believes that this hypothesis is likely to get ignored by mainstream academics.  In short he is selling an idea others don’t want to buy.

My best guess is that Eric is basically right.  In fact, I’d guess lower returns for the highest risk investments come from enough investors being risk-loving in relative wealth; they are willing to lose out on average for a chance to gain the very most.  However, even if Eric is eventually proven very clearly right, I’m not optimistic that he will get much credit or gain from it.

In his research paper Falkenstein shows how in a variety of market, and market-like, settings individuals prefer lottery-like payoffs.  This preference leads to the risk-return relationship getting muddled.  For example one should expect to see high growth countries, like those in the emerging markets, outperform slower growing countries.   However the evidence is just the opposite.  Low growth countries outperform.  Financial history is full of these seemingly paradoxical results.

Another of his conclusions is that after after a series of reasonable adjustments the equity risk premium is indistinguishable from zeroHistorical data issues aside, there has always been some debate on the size of the equity risk premium there was little doubt in academia that is well-exceeded zero.  One area that Falkenstein includes in this is the poor timing of individual investors.  For example, Michael Stokes at the MarketSci Blog recently noted how his subscribers are “forever chasing the hot hand.”  While this not typically included in the ERP it does represent a practical aspect in investing.

Not surprisingly there are some implications for investing that flow from these hypotheses.  The first is that there are relatively few reliable sources of risk premia.  Two come from the world of fixed income.  One can on average earn a premium to extending maturities above and beyond cash equivalents.  The second is that there is return to credit in the range of the Aaa-Baa spread.  Moving much beyond gets into that risk-seeking zone where the risk-return relationship falls apart.

In the realm of equities the results are paradoxical at first glance.  Investors can build portfolios with a better risk-reward relationship by shunning risk.  Portfolios built to minimize portfolio risk have historically performed better than the market at lower risk.  (I smell an ETF…)  These are just a few of the tactical implications from Falkenstein’s work.

Given space considerations, the point of this post was not to reiterate his underlying theses or conclusions.  Falkenstein does a much better job explaining them that we can.  Indeed he has made his thoughts available in a number of forms:

The book:  Finding Alpha: The Search for Alpha When Risk and Return Break Down;

In video form:  Finding Alpha Videos;

Research paper:  “Risk and Return in General:  Theory and Evidence“; and

The blog:  Falkenblog.

The economic crisis has destroyed a number of investing shibboleths.  Now might be an apt time to re-examine the fundamental assumptions underlying our portfolio management processes.  During the dog days of August when the market has slowed down it may be worth spending some time thinking about how we might go about doing this.