Missing Risk Premium: a Synopsis

I recently made a presentation of my book, The Missing Risk Premium, and thought it was concise, so I'm sharing it here.

Historical return data contradicting 'expected return positively linearly related to risk' theory:

• Within equities:
• Firm leverage
• Firm profitability
• CAPM beta
• Total Volatility
• Residual Volatility
• Financial Distress/Default metrics and equities
• Penny stocks vs. regular stocks
• IPOs vs regular stock
• Country returns in developed countries
• Country returns in emerging markets
• Analyst disagreement across stocks
• High vs. low trading volume
• R rated movies vs. G rated movies
• Volatility/future equity Index returns  over time
• Overnight vs. Intraday stock returns
• Bond credit: Distress, Junk, and  BBB-A rated Bonds
• Bond duration: post 2 years
• Out-of-the-money options vs. at-the-money options
• S and C corps  vs. equity indexes
• Senior vs. Subordinated
• Reinsurance: rebalanced vs. peak peril
• Converts: low and high moneyness
• Merger Arbitrage: stock-financed vs. cash-financed
• Lotto vs. ‘quick pick’ lotteries
• 50-1 horses vs. 3-1 horses
• Mutual funds
• Hedge Funds
• Commodity Trading Advisors (CTAs)
• Currencies
• Futures
• Real Estate

Data consistent with Risk/Return theory:

• Short end of yield curve
• BBB-Treasury credit spread
• Top-line equity return over libo

How high risk generates low premium:

Winner’s curse: excess demand for volatile stocks generates below average returns
Why the extra demand?

• Overconfidence
• Information costs lower about risky firms
• High returns have high risk, ergo risk implies higher return fallacy
• Some are risk loving
• Some people are positive skew loving
• Alpha discovery
• Easier sell to clients (amenable to stories)
• Payoffs to fund managers
• Bounded rationality  (think SML is positively sloping)
• Agency problem (exploit option with fund source)
• Those buying stocks think stocks will rise, in which case higher beta is better

Why is Flat/downward SML  not arbitraged?

• Tradition (60-40 stock/equity ratio is a binding constraint)
• Irrationality (others don’t notice SML flat/negative)
• Relative risk (my favorite, other consistent data below)
• Easterlin Paradox suggests happiness is relative
• No one sells low risk, lower-than-average return stocks, because in a relative risk world, one only takes risk if the return is above average
• home bias because you want to outcompete your peers, not strangers
• Relative orientation evolutionarily robust compared to a Constant Relative Risk Aversion utility (which would be a strange coincidence)
• Glucocorticoid levels such as cortisol related to status, not wealth
• Imitation generally dominates figuring things out oneself (eg, fire, calculus), leading to an other-person directed brain
• fMRI identifies neural mechanisms for empathy, social information
• Status is a human universal, greed is not
• Reverse dominance hierarchies in humans common (ie, status more important than wealth)
• Politics about redistribution more than efficiency

Counter: If Risk has no Premium, why take risk?

• 40% of all men reproduce, where 80% of women do. 
• Men have out-of-the-money option, need to take risk
• Why not take infinite risk? Moderation in all things.
• Life is a complex, nonlinear, dynamic game where every parameter has a local maximum. Radiation, vitamin A, oxygen, tolerance,  risk taking, can all be too much or too little.

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