Book Review: Finding Alpha
The Search for Alpha When Risk and Return Break Down
Overview
Falkenstein challenges some of the most widely accepted ideas in finance, specifically those underpinning the Capital Asset Pricing Model (CAPM) and modern portfolio theory. He presents a thorough critique of these models and highlights the flaws in the assumptions that form their basis. Falkenstein’s arguments are not just theoretical but are backed by a blend of empirical evidence.
At the heart of Finding Alpha are two key theses:
Risk is Not Always Rewarded: Contrary to the conventional belief that higher risk leads to higher returns, Falkenstein argues that, on average, risk does not translate into additional reward. In fact, portfolios of low-risk stocks often outperform their high-risk counterparts.
Relative Risk Matters More Than Absolute Risk: Investors, Falkenstein asserts, care more about how their returns compare to others than about absolute losses. Fear of underperforming a benchmark or a neighbor is a bigger motivator than worrying about losses in a vacuum.
These arguments, along with his critique of established financial models, form the backbone of the book.
Critical Examination of the CAPM and Modern Portfolio Theory
Falkenstein begins with a historical overview of the Capital Asset Pricing Model (CAPM), explaining its origins and theoretical underpinnings. The CAPM posits that an asset’s expected return is a function of its risk (beta), where investors are compensated for taking on systematic risk. However, Falkenstein systematically dismantles this model, showing that it fails to explain much of the observed market behavior and the returns investors actually experience.
In particular, he points out that the empirical evidence does not support the idea that markets reward risk in the way CAPM suggests. Instead, he presents the argument that riskier assets do not consistently deliver higher returns over time, a concept that directly challenges the core tenet of modern portfolio theory and other models that rely on the assumption of risk-return compensation.
Risk Premium and Alpha
One of the book’s most groundbreaking insights is Falkenstein’s argument that risk is (on average) not rewarded. He explores this by focusing on the concept of the risk premium—the extra return investors expect from risky assets. His analysis reveals that low-risk stocks often provide higher returns than high-risk ones, which flips the traditional understanding of the risk-return relationship on its head.
This leads directly into the concept of alpha, the excess return of an asset or portfolio beyond what can be explained by exposure to systematic risks. Falkenstein argues that much of what is perceived as alpha may actually be the result of exposure to certain systematic factors—such as value, size, momentum etc., rather than any special investment skill or insight. He emphasizes that a deep understanding of these factors and their associated risks can help investors identify more consistent sources of return, rather than relying on traditional, skill-based approaches to beating the market.
Relative vs. Absolute Wealth
In addition to his critique of financial models and risk premia, Falkenstein delves into the psychology of investors. One of the key insights from Finding Alpha is the idea that investors are more concerned with relative risk than with absolute risk. In other words, investors care less about how much money they might lose in absolute terms and more about how their performance compares to that of others, especially a benchmark.
Falkenstein argues that this concern with relative performance drives a lot of investment behavior. It leads to phenomena such as herding as well as loss aversion, where investors are more afraid of underperforming their peers than of suffering absolute losses.
Is Finding Alpha Worth Reading?
For investors familiar with factor investing or those interested in quantitative finance, Finding Alpha is an absolute must-read. The book provides a fresh, critical perspective on the nature of risk, return and alpha. It also presents compelling evidence against the traditional assumptions of modern finance. It is recommended for:
Quantitative investors & academics: Highly recommended—a thought-provoking read on risk, alpha and market anomalies.
Other investors: Selective read—valuable insights, but requires persistence and critical thinking.
However, it’s not without its drawbacks. The book is not particularly accessible for beginners in the field of (quant) investing (not intended to be one) and the language is quite academic. While the first chapters are engaging and informative, the middle section becomes somewhat repetitive and the book loses some of its earlier momentum. That said, the final chapters are where the book truly shines, as Falkenstein offers practical insights into how investors can exploit factors and find alpha.
An updated second edition would be highly desirable, especially considering the advancements in factor investing both academically and practically since its publication in 2009. Additionally, the book is apparently no longer in print and therefore difficult to find and often comes with a premium price tag.
Conclusion
Falkenstein successfully questions the widely accepted models of risk and return, offering a more nuanced view of how investors should approach the search for alpha. While the book may not be for beginners, it is a treasure trove of insights for anyone serious about understanding the complexities of financial markets and how to capture systematic alpha.
If you’re looking to deepen your understanding of risk, alpha, factor investing and the limitations of traditional investment models, Finding Alpha is definitely worth your time.
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Disclaimer
The above article constitutes my or the authors’ personal views and is for entertainment purposes only. It is not to be construed as financial advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. I / The authors may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this article. The information provided in this article is not making promises, or guarantees regarding the accuracy of information supplied, nor that you guarantee for the completeness of the information here. The information in this article is opinion-based and that these opinions do not reflect the ideas, ideologies, or points of view of any organization the authors may be potentially affiliated with. The authors reserve the right to change the content of this blog or the above article. The performance represented is historical” and that “past performance is not a reliable indicator of future results and investors may not recover the full amount invested.