The Missing Risk Premium: Why Low Volatility Investing Works

The Missing Risk Premium:
Why Low Volatility Investing Works

Eric Falkenstein
2013
Copyright 2013 Eric G Falkenstein 1

Who am I
• I’m an economics PhD who has worked as a quant,
risk manager, and portfolio manager. See more at
the following websites
– www.betaarbitrage.com
– Falkenblog
– www.efalken.com
• Old Book Finding Alpha (2009)
• New Book The Missing Risk Premium, out this
spring

My Interest
• My 1994 dissertation, first 3 sentences:
– “This paper documents two new facts. First, over the past
30 years variance has been negatively correlated with
expected return for NYSE&AMEX stocks and this relationship
is not accounted for by several well-known prespecified
factors (e.g., the price-to-book ratio or size). More volatile
stocks have lower returns, other things equal.”
• So, risk premiums and low-vol have been a bit of a

hobby-horse

The Stakes
“It is impossible to appreciate how the financial
system works without understanding risk.”
Stephen Cecchetti
"Risk is not an add-on … it permeates the whole
body of thought.“
Robert C. Merton

“most returns and price variation
come from variation in risk premia”
John Campbell
E  FutValue 
Price 
1 r  g
Risk free Risk premium

rate

Big Idea: this is the Risk-Return Trade-off

Risk and Return
• In general, in practice:
risk is not positively related to return

Standard Theory is Intuitive
• Risk aversion like aversion to smelliness
• The logic applied to this idea, via a utility
function that has decreasing marginal returns,
generates many mathematically consistent
results that seem highly plausible

…And Wrong
Leveraged Firms
B vs. BBB rated Bonds
Out-of-the-money options vs. at-the-money options
S and C corps vs. equity indexes
Highest volatility vs. modest vol stocks
R rated movies vs. G rated movies
Lotto vs. ‘quick pick’ lotteries
50-1 horses vs. 3-1 horses
Mutual funds, currencies, futures, countries, yield curve

Finance Misleading
• Most practical finance is about generating
expected values
• Finding covariances to generate different
discount rates is a massive waste of time,
pure rationalization in practice

Conspiracy?
• Economists find standard utility functions
much more productive (in theory)
• Asset managers can justify anything via ‘risk’,
which is omnipresent and as yet
unmeasurable
• Amenable to rigorous sequence of lectures

Standard Theory

Marginal Utility
St. Petersburg Paradox (1738): what is value of $1
paid if you get a head in a coin flip, where the
payoff is (number of times coin flipped)^2?
Should1 be1infinity
1 1
E  1   2   4   8  ...
2 4 4 16
1 1 1 1
E      ...
2 2 2 2
 1
E   j 1  
2
Why not? Diminishing marginal returns

Basic Idea of Utility
• Fundamental to economic reasoning
• Marginal Revolution transformed economics
in 1860s
– Walras, Jevons, Menger
– Pre 1860s ‘classical’ economists: Marx, Smith,
Ricardo, Mill
• Transformed Theory of Value

Where does Risk Premium Come From?
• Global concavity of utility is the necessary and
sufficient condition for the existence of a risk
premium

Utility Theory and Risk Aversion
• Utility not applied between goods, but to
everything
• Von-Neumann-Morgenstern (1944)

Iso-Utility Curves for Return and Volatility
U  E  r   a 2
Why we like efficient portfolios
No points plot above

the red line
100% investment in security
with highest E(R)
Expected Return
All portfolios
on the red line
are efficient
100% investment in minimum
variance portfolio
Standard Deviation

Tobin: Two-Fund Separation Theorem
Exp
Return Port-1
U1
U2
Port-2
U3
U4 Port-3
Volatility 
Always hold some cash: liquidity
preference
Expected Return
C
Rz   1  z  rf  zrB
 z  z B
B
Rf
A
Standard Deviation

Regardless of risk preference, everyone uses
same risky portfolio

How to Derive The Capital Asset Pricing
Model
1. E  ri   a im  k every asset has same marg. value
2. E  rf   a fm  k  rf  k ,risk free rate is k
E  rm   rf
3. E  rm   a m2  k  a 
 m2
E  rm   rf
4. E  ri    im  rf
 m2
 im
2 
5. E  ri   rf  E  rm   rf 
m
6. E  ri   rf  i  E  rm   rf  aka the CAPM the SML

CAPM is the Security Market Line
(SML)
Market Portfolio
Expected Return E ( Ri )  R f   i  E ( R m )  R f 

where E ( Ri )  expected return on security i
E(R)
R f  risk-free rate of interest
 i  beta of Security i
E ( R m )  expected return on the market
Rf
1.0 Beta

General Equilibrium aka Stochastic Discount
Factor  CAPM
U1'  U 0'    cov( Ri , Rm ) 
1. U  EU   1  r 
'
0
'
1  1  E ' 1 r  7. E[ R]  R f   '   
U0  U1   U 0' 
U1'
2. 1  E  MR  given M= ' 8. E[ R ]  R f 
 cov( Ri , Rm )
U0 U1'
3. E[ MR]  E[ M ]E[ R]  cov( M , R)  1 9. letting R i =R m U1' 
 var( Rm )
E[ Rm  R f ]
1 cov( M , R )
4. E[ R]  
E[ M ] E[ M ]  cov( Ri , Rm )
10. E[ R]  R f 
  var( Rm ) 
1  
5. E[ R f ]  R f   E[ Rm  R f ] 
E[ M ]
cov( Ri , Rm )
U1' - Rm 11. E[ Ri ]  R f  E[ Rm  R f ]
6. M  '  var( Rm )
U0 U '0
 cov( Ri , Rm ) 12. E[ Ri ]  R f   E[ Rm  R f ]
U ' 1 cov( M , R)  
Rm U 0'

Asset Pricing Theory Was Always Treated
Well
• 1971 Institutional
Investor :“The Beta Cult: The
New Way to Measure Risk.”
• Contrast with almost
constantly ridiculed Efficient
Markets Hypothesis, which is
much more successful (eg, it’s
hard to outperform the
indices)
Hope for Final Theory
• linear in risk factors, covariances with
something
• include something very like the stock market
as one of the prominent factors

Empirical Evidence

Volatility Often Used as a Risk
Shorthand
Brealey and Myers Investments Book
Return Volatility
Small Stocks 17.30% 33.4%
Stocks 13% 20.2%
Corporate Bonds 6.0% 8.7%
Government Bonds 5.70% 9.4%
T-bills 3.90% 3.2%
From Cam Harvey (editor

of Journal of Finance)
website

If only this worked in more places…

The Risk Premium Problem
After 45 years, there are no measure of risk that are generally
positively correlated with returns
Fama and French 1992
From Campbell
2000
Fama-French (1992)
• Show beta is just a size effect
• Founding father (Fama) admits CAPM is
‘incomplete’, and beta itself useless

Example of how small firm effect showed up in
beta tests
Theory:
Longer hair people
are short
Omitted variable:
gender
Theory:
high beta firms have
high returns
Omitted variable: size

CAPM Recognized as Empirical Failure
• “More empirical effort may have been put into testing
the CAPM equation than any other result in finance.
The results are quite mixed and in many ways
discouraging.”
– Mark Rubinstein
• “empirically vacuous,”
– Fama and French
• “having a low, middle or high beta does not matter;
the expected return is the same.
– Stephen Ross

A Survey of Empirical Anomalies to the
Standard Model
• The standard theory involves a specific metric
of covariance, and so it could be, we simply
haven’t found the right one
• As a ‘framework’, not a theory, it is non-
falsifiable
• However, it’s hard to conceive of one not
correlated with total volatility

Total Volatility and Returns
• My Dissertation (1994) page 53

Cross-Sectional Annual Returns Sorted by
Idiosyncratic and Total Volatility
Ang,, Hodrick, Xing and Zhang (JoF 2006)

Beta and Returns: 1962-2011
Beta-Low Beta0.5 Beta1.0 Beta1.5 Beta-High

AnnRet 10.8% 11.4% 11.4% 8.2% 4.5%
AnnStdev 13.1% 11.6% 17.4% 26.2% 33.9%
Beta 0.57 0.57 1.04 1.44 1.78
Equities and bond ratings (Distress)
• Low Rated Equities also have lower returns
StockReturns
AAA 12.4%
AA 13.9%
A 14.3%
BBB 14.2%
BB 15.0%
B 8.6%
C -12.7%

Leverage and Equity Returns
Penman, Richardson, and Tuna. 2007
Equity Returns Practice Theory

Penny Stocks: Eraker and Ready
(2009)
Volume($)
> 2,000 50,000 500,000
Price> 0.01 0.1 0.01 0.1 0.01 0.1
Count 7372 6685 6423 5757 4603 3939
AnnReturn -29.1% -35.4% -9.1% -13.5% -34.2% -41.0%

Call Options
Sophie Ni (2007)
Should amplify the equity risk premium the greater the out-of-the-money

Initial Public Offerings (IPOs)
• IPO has a lot of Uncertainty
• Jay Ritter (see his website). 1970-2011.
• 8k observations

Analyst Disagreement
• Deither, Malloy, and Scherbina (2002). Table
2. Data from 1983-2000.

Total Volatility over Time
• Steve Sharpe and Gene Amromin (2005).
People have higher expected returns when
they have lower expected volatilities
 
E rm  rf  a m2  b mf
a, b  0

Total Volatility over Time
• Contemporaneous Correlation Clearly
Negative
 
E rm  rf  a m2  b mf
a, b  0

SPY Total Return to Overnight vs. Daily
Return Periods

Small Business Returns
• Moskowitz, and Vissing-Jorgensen (2002)

Currencies: Uncovered Interest Rate Parity
rAUD  ryen  % change in yen+riskprem?
Sharpe 0.99 from 1976-2008 in Burnside et
al (2009)
Here’s Long AUD, Short JPY

Corporate Bonds
• Merrill High Yield Master II (HOAO) Merrill
BBB-AA Index (COCO)
• Indices here overstate realized returns

World Country Returns
• Dimson, Marsh, Staunton (2005)
• 17 Countries, 1900-2005, Annual Data

Emerging market Returns

Treasury Yield Curve
• 1% premium from 0.25 to 3 years
• No premium from 5 to 30 years
• Volatility, Covariance, increasing linearly

Treasury Yield Curve
• 1% premium from 0.25 to 3 years
• No premium from 5 to 30 years
• Volatility, Covariance, increasing linearly

Futures
• Futures return from roll
• Harvey and Erb (2007) copper, heating oil, and
live cattle were on average in backwardization,
• corn, wheat, silver, gold, and coffee were in
contango
• It isn’t clear what covariance, volatility has to
do with this

Movie Returns by Rating
• Devany and Walls (1999), 2015 movies from
1984-96

Sports Books: Longshot Bias
• Snowberg and Wolfers (2009)

Initial Public Offerings (IPOs)
• IPO has a lot of Uncertainty
• Jay Ritter (see his website). 1980-2008.
• IPO Returns -3.7% annually below size-
matched firms for first 5 years

Trading Volume
• Turnover of stock a proxy for disagreement
• Highly correlated with beta

Equity Risk Premium
• Top line return is not the same as average or
marginal return

What is the Equity Risk Premium?
Eri  rf  E  i  rm  rf 
E  rm  rf 
The most important constant in finance

Equity Premium Evolution
• Lorie and Fisher (1964): 9.0% raw return (no bond return)
• Ibbotson and Sinquefield (1976): 10.9%
• Mehra and Prescott (1986): 6.2%
• 1999 Barclays and CSFB estimated 8.8%
• Ibbotson (1926-97): 8.9%
• Finance Texts (1998): 8.5%
• Ivo Welch Survey (1998): 8.5%
Crash!
• AIMR estimate (2002): 3.0%
• WSJ survey (2005): 2.0%
• CFO Magazine (2005): 5%
• Ivo Welch (2009): 2%-4% at most 1%-8%

Geometric vs. Arithmetic Averages
• 1 to 2 to 1 has a total return of 0%
• 100%, -50% return has average of 25%
• Arithmetic returns useful if you rebalance, as
opposed to invest all your money at inception
• Stock returns have volatility around 20%, for
the indices, which implied a 2% adjustment
 2
rG  rA 
2
Bad Market Timing
• Dichev (2005)
• 1, 2, 1
–  return 0% if cf is {-1,0,+1}
–  return -17.7% if cf is {-1,-1,+1.5}
• Total return different than Internal Rate of Return based on
timing of investments
• Distributions  Dividends-New Money

• Corr(Distributionst,Returnt+1)= +33%
• Corr(Distributionst+1,Returnt)= -27%
•  bad timing

Transaction Costs
• Commissions,
– 8.5% load through 1970’s to buy a mutual fund
• bid-ask cross
– Stocks quoted at 8 ¾ - 9 in the 1990s
– buy at 9, sell at 8 ¾, lose 2.78%
– Phantom cost: most investors don’t know real time prices
• Stoll and Whaley (1983) 1.78% comm+bid-ask
• Bhardwaj and Brooks (1992): 4.4% total
• Currently very low if you are smart (0.2%)

Survivorship Bias
• USA primary data point in World Value Weighted Index
• Coincidentally,
– 2-0 in World Wars
– Never went communist
• Brown, Goetzmann, and Ross (1995)
– Czechoslovakia, Hungary, Poland, Russia, and China all
zeroed out
• Jorion and Goetzmann (1999)
– US real return 350 basis points above median for 39
countries in 20th century

Peso Problem
• Peso-Dollar FX rate fixed from 1954-76
• Higher interest rate in Peso
• Peso ‘floated’ in 1976: lost 45%
• Peso devalued by 82% in 1982
• Small probability, big loss, explains interest rate
premium
• Robert Barro (2006) argues a correct probability of a
significant catastrophe explains much of the equity
premium, about 300 basis points
– 2% change of a 15% to 45% GDP decline

Taxes
• 10% stock return: 6% post tax with a 40% tax rate
• Gannon and Blume (2006) apply this to S&P500 assuming
20% turnover from 1961-2005, using actual capital gains,
dividend top-tier tax rates
• Cap gain avg: 26%
• Top tax rate avg; 49% (includes 6% state tax)
• Lorie and Fisher (1964) found 2.2% adjustment
• Total after tax equity return 6.72%, vs. 10.62% pre tax
• Long Term Municipal Bond Buyer Index return: 6.14%

People ignore costs all the time
• Beardstown Ladies investment club
• 1983-94 return 23.4%
• Best selling authors
• Audited financials: 9.1%, below 14.9% for
market
• Failed to include contributions

Investors Don’t Match Indices
• Dalbar study from the Investment Company
Institute:
• 1990-2010 Annual Returns
• S&P500 return: 9.1%
• Average equity mutual fund investor: 3.3%

Returns not Like in Representative Agent
Model
Equity Return Uncorrelated with GDP growth over

a Century Copyright 2013 Eric G Falkenstein 70
Hedge Fund Money Goes to Insiders
• From Simon Lack

Equity Premium Subtractions
• Geometric vs. Arithmetic Averaging 1.0%
• Survivorship Bias 1.0%
• Peso Problems 1.0%
• Taxes 1.0%
• Adverse Market Timing 1.0%
• Transaction Costs 1.0%
• Sum 6.0%
• Most estimates around 3.5% for equity premium.

With these additions, the Marginal Investor
clearly could be seeing a 0% equity premium.
Scope of the Risk Premium Failure
Positive Risk Premium (3) Zero Risk Premium (14) Negative Risk Premium (12)
1. Short End of Yield Curve 1. Long-End of Yield Curve 1. Average Equity Investor
2. BBB-AAA Corporate 2. B to BBB Bond 2. Betas
Spread 3. Futures 3. Volatility
3. Efficient Equity Investor 4. Private Investments 4. Financial Distress
5. Movies 5. Trading Volume
6. Mutual Funds 6. Analyst Disagreement
7. VIX and Equity 7. Equity Options
8. World Equity 8. Lotteries
9. Emerging Markets 9. Sports Betting
10. Hedge Funds 10. Currencies
11. Real Estate 11. IPO equity Returns
12. CTAs 12. MVPs
13. Private Equity
14. Intraday Stock Return

New Theory
• In general, risk and return are uncorrelated
because risk is a deviation from the consensus
• This makes risk symmetric, too much or too
little exposure generates similar risk
• Thus, volatile assets don’t need extra return to
be held…

Basic Idea of Relative Risk and no Premium
Total Return Avg. Relative Return
X Y X Y
State 1 0 -10 –5 5 –5
State 2 20 30 25 –5 5

Utility Proof
• Taking the first order condition, we have
m = R f + a s 2 ( a Ei - a E- i )
a Ei = a E- i
• Since each agent is identical, in equilibrium

each agent holds the same amount
• So m = Rf
• Which means, the expected return on risky
assets is te risk free rate
Utility Proof Benchmark
• Taking the first order condition in the standard model
we have
m = R f + a s 2a Ei
• This is the standard result, that higher volatility

generates a higher return, linear in the variance,
adjusted by the coefficient of risk aversion
• Because the exponential utility is CARA, not CRRA,
higher amount in the risky asset generates a higher risk
premium
Relative Utility and Different Beliefs
• See how relative utility model explains
– Why when investors take risks, they expect above
average returns
– Returns are relative to the risk free rate
– Don’t short assets with expected return<Rf
m = R f + a s 2 ( a Ei - a E- i )
m = R f + a s 2a Ei

Relative Risk in academia
1
 ct 
• Abel (1990):  t t 1     C 
1
U c , C  1  
 t 1 
    1 a  a 1
• Gali (1995): U c , C  1  a c C
• DeMarzo,, Kandiel, Kremer (2003):

U  cg , cs    1  a 
1
c 1 a
g
1 a
c
s 
C1 a  W i

• Roussanov (2010):  Ws 
1 a s

1 a  Ws 
Outside the Box Evidence
• Like any truth, it has lots of footprints

Easterlin’s Paradox (1974)
• Within a society, rich people tend to be much happier than poor people.
• But, rich societies tend not to be happier than poor societies (or not by much).
• As countries get richer, they do not get happier.

Easterlin’s Paradox
• Progress and Happiness a Puzzle
– Gregg Easterbrook’s The Progress Paradox,
– David Myers’s The American Paradox, and
– Barry Schwartz’s The Paradox of Choice
• Japan: between 1958-1987 per capita income rose 500%
– No change in subjective well-being
• Knight and Song (2006): Chinese villagers more affected by relative than
absolute wealth, compared to their villages
• Choose between
– World A: $100,000 a year in perpetuity while others earned $90,000
– World B: earn $110,000 while others earned $200,000
– Most prefer World A

Buy Recommendations exclude low risk firms
• Half of all stocks have expected returns below the market

• Zero recommendations for firms with expected returns below
the market return
Buy!
Expected Return
Who
cares?
Risk

Home Bias
• Should invest in world portfolio
• Chan, Covrig, and Ng (2005): Everyone is
investing mainly in domestic portfolio
• Avoiding easy way to diversify risk
• Low covariance with risks from home
economy

Everyone Benchmarks
• “I want a product to be defined relative to a
benchmark”
Bill Sharpe
• ‘Risk, see Benchmarking’
Kenneth Fisher’s Only Three Questions that Count
• “small stocks were in a depression” in the 1980’s

Eugene Fama, Merton Miller

The Most Prominent Economists Can Be Read
as Relative Utility Proponents
• “…rank among our equals, is, perhaps, the strongest of all our desires.”
– Adam Smith
• “Men do not desire merely to be rich, but to be richer than other men.”
– John Stuart Mill
• “any individual or group of individuals, who consent to a reduction of money-
wages relatively to others, will suffer a relative reduction in real wages, which is
sufficient justification for them to resist it”
– JM Keynes
• “The motive is emulation–the stimulus of an invidious comparison... especially in
any community in which class distinctions are quite vague”
– Thorsten Veblen
• Our wants and pleasures have their origin in society; we therefore measure them in
relation to society; we do not measure them in relation to the objects which serve
for their gratification.”
– Karl Marx , Wage Labour and Capital, chapter 6

Hard Wired For Envy
• Relative Status makes more evolutionary
sense than absolute wealth as a utility
function
• Evidence for this instinct

Evolutionary Biology
• genetic success is always relative, why spite
works

Evolutionarily Robust
• Special Utility needed for interest rate to be
C1 a
stable over generations U  C  
1 a
• But then, refinement really has to vary
• Eye cones and color
• Rayo and Becker (2007)

Reverse Dominance Hierarchies
• Chris Boehm
• primates usually have dominant males
• With tools, easy to kill dominant males, so
hierarchies are not ‘natural’ for humans

Imitating Others Dominant Strategy
• We copy all the time: parents, then peers,

then anyone doing well
• Mark Pagel: zero, soap, the wheel, language,
iPads.
– Division of labor, accumulation of science, implies
innovating only after a lot of copying, and
generally relying on others

Social Context Hard Wired
• Specialized neural mechanisms process social
information, empathy
• Can’t ‘not see’ context
• Mirror neurons tie others to us

Relative Utility Matters more than Absolute
• Econometrics
• fMRI
• Psychologists
• rank in one’s peer group is more important
than the level of income

Endocrinology of Envy
• Robert Sapolsky found baboon status related

to glucocorticoid levels
• Whitehall Studies found correlation between
British civil servant grade level and mortality.

Moderation in All Things
• Greek proverb
• too much, too little, both bad:
– Vitamin A
– Radiation rd
da
– Oxygen Risk an
– Politeness
Relative St
– Loyalty
– Honesty
- 0 
Exposure
Courage Premium
• Aristocracy asserted their privileged position
came from battlefield courage
• The upper classes truly were courageous in
battle, as WW1 showed, but no one will pay
for that, and taxes on the rich went up

Why Take Uncompensated Risk?
• Necessary, not sufficient condition for success
• Every irrevocable act entails some kind of risk
– We all take risks (marriage, jobs)
• Taking the right risks, at the right time, given
our particular strengths, is good

Why a Negative Premium?
• With relative risk, an abnormal demand for
highly volatile assets is not totally countered in
equilibrium, leaving a price impact
• Higher demand, higher price, lower future
return
• Without relative utility, one needs ad hoc
constraints

High Vol Demand: Winner’s Curse
• If no short selling….assets with higher valuation
uncertainty will have higher prices, lower returns

High Vol Demand: Overconfidence
• People are generally overconfident about their
relative competency on socially desirable
trates
• Overconfidence makes one happier, lowers
mortality

High Vol Demand: Risk-Loving
• Preference for positive skew
• Consistent with global risk aversion only if
skew risk premium <15% of standard risk
premium
• Risk loving looks like overconfidence

High Vol Demand: Gambling Preferences
• Robert Sapolsky and dopamine generation

based on rewards:
– Higher for probabilistic payoffs

High Vol Demand: Information Costs
• High volatility stocks generate more news

– Easier to form opinion
– Easier to sell a story
• Falkenstein (1996) looked at mutual fund
ownership and news stories, stock age

High Vol Demand: Representativeness Bias
• Great stocks of past had great risk….
• “To get rich, you have to take risk.”
• Prob( higher return|higher risk)=Prob(big return|big risk ) >0
– So risk is correlated with higher returns (?)
P  A   prob risky
P  B   prob high return
P  A | B P  B
P  B | A 
P  A
High Vol Demand: Alpha Discovery
• Many people jump in and want to know if they
have ‘it’
• Trade bio-techs, not utilities

High Vol Demand: Convex Payoffs to Stock
Pickers
• Top stock analysts often have 100% winners
• Mutual fund inflows highly convex
– Greater value to greater volatility via call option

High Vol Demand: Asset Buyers Bullish
• Most equity buyers tend to think the market is

going to rise more than the ‘equity risk
premium’
• Given those beliefs, it

Academic Confabulations

Praise for a Vacuous Theory
‘it would be irresponsible to assume that [the CAPM] is not true’
William Sharpe
‘theoretical tour de force’ though ‘empirically vacuous’

Eugene Fama
‘stochastic discount factor(s) … so general, they place almost no

restrictions on financial data’
John Campbell
Finance is “the only part of economics that works”
Andy Lo

Snipe hunt for factor that works
• Oil prices
• Consumption growth
• Per-capita labor income
• Consumption/wealth ratio
• Statistical (latent) Factors
• Etc.

Implications

MVP Construction
• Find weights with added constraints
– No shorts
– Cap on weight of 2% for S&P500, 4% for other
indices
– Stocks found generally at max limit for longs
– Redo each 6 months based on daily data from
prior year Min w HFA w
s.t. w '  1
0  wi  0.02  i

Indexes are not near 'Efficient'
FTSE- MSCI- MSCI- Nikkei- S&P500-
FTSE MVP Eur MVP Nikkei MVP S&P500 MVP
AnnRet 2.7% 7.4% -0.6% 2.6% -1.6% 0.0% 4.2% 9.2%
AnnStdev 15.0% 12.0% 19.5% 13.1% 19.8% 13.5% 16.5% 12.3%
Beta 0.65 0.59 0.50 0.47

Beta Strategies
Beta-Low Beta-05 Beta-10 Beta-15 Beta-High S&P500
GeoMean 11.3% 11.9% 12.2% 9.6% 6.4% 10.1%
AnnStDev 13.0% 11.6% 17.4% 26.2% 34.4% 15.1%
Sharpe 0.45 0.56 0.39 0.16 0.03 0.31
Inf. Ratio 0.10 0.22 0.21 0.15 -0.02
SMB Beta 0.53 0.34 0.69 1.45 1.78 0.26
HML Beta -0.06 0.10 -0.29 -0.96 -1.35 -0.39
Mkt Beta 0.60 0.57 1.04 1.44 1.82
Data from Jul-1962 to Jun-2012 monthly returns, annualized used top
80% of NYSE market cap (about 1500 stocks today)
Portfolios with 100 stocks
Total Vol vs. Beta vs. IdioVol
• Top 2000 stocks, extrapolated backward,
1952-2008, Sorted differently
Volatility Beta Idio

low high low high low high
Arith 10.3% 7.9% 12.1% 11.1% 10.5% 9.0%
Geo 10.2% 2.2% 12.0% 5.3% 10.5% 3.7%
Stdev 10.2% 33.5% 11.9% 34.1% 10.2% 32.5%
Sharpe* 1.00 0.07 1.01 0.16 1.03 0.11

Investment Advisor
• Assume people want to do what everyone else
is doing
– Appealing asset allocation based on consensus,
not volatility
• Sell idea of trading envy for greed
• MVPs
• Beta Arbitrage
• Will deviate from the benchmark

Implication
• Focus on payoffs and probabilities
– not expected returns
– Not discount rates
• Don’t derive an expected return from a covariance or factor
loading
E  ret   a 2
E  ret   a pi

Implications
• Don’t expect to be rewarded for risk taking per
se
• Accept some envy; moderation in all things
• People like being appreciated: it shows they
are relatively competent, a status maximizing
metric

The Missing Risk Premium: Why Low Volatility Investing Works

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The Missing Risk Premium:

Why Low Volatility Investing Works

Copyright 2013 Eric G Falkenstein 1

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• So, risk premiums and low-vol have been a bit of a

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Risk free Risk premium

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Why not? Diminishing marginal returns

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No points plot above

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2. E  rf   a fm  k  rf  k ,risk free rate is k

6. E  ri   rf  i  E  rm   rf  aka the CAPM the SML

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Expected Return E ( Ri )  R f   i  E ( R m )  R f 

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From Cam Harvey (editor

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Beta-Low Beta0.5 Beta1.0 Beta1.5 Beta-High

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Equity Returns Practice Theory

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AnnReturn -29.1% -35.4% -9.1% -13.5% -34.2% -41.0%

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