Eric Falkenstein has an interesting argument in his paper Risk and Return in General: Theory and Evidence. He proposes what is essentially a relative strength argument about risk and return. He contends that investors care only about relative wealth and that risk is really about deviating from the social norm. Here is the summary of his draft from the excellent CXO Advisory:
Directly measured risk seldom relates positively to average returns. In fact, there is no measure of risk that produces a consistently linear scatter plot with returns across a variety of investments (stocks, banks, stock options, yield spread, corporate bonds, mutual funds, commodities, small businesses, movies, lottery tickets and bets on horse races).
- Humans are social animals, and processing of social information (status within group) is built into our brains. People care only about relative wealth.
- Risk is a deviation from what everyone else is doing (the market portfolio) and is therefore avoidable and unpriced. There is no risk premium.
The whole paper is a 150-page deconstruction of the flaws in the standard model of risk and return as promulgated by academics. The two startling conclusions are that 1) people care only about relative wealth and that 2) risk is simply a deviation from what everyone else is doing.
This is a much more behavioral interpretation of how markets operate than the standard risk-and-return tradeoff assumptions. After many years in the investment management industry dealing with real clients, I’ve got to say that Mr. Falkenstein re-interpretation has a lot going for it. It explains many of the anomalies that the standard model cannot, and it comports well with how real clients often act in relation to the market.
In terms of practical implications for client management, a few things occur to me.
- Psychologists will tell you that clients respond more visually and emotionally than mathematically. Therefore, it may be more useful to motivate clients emotionally by showing them how saving money and managing their portfolio intelligently is allowing them to climb in wealth and status relative to their peers, especially if this information is presented visually.
- Eliminating market-related benchmarks from client reports (i.e., the reference to what everyone else is doing) might allow the client to focus just on the growth of their relative wealth, rather than worrying about risk in Falkenstein’s sense of deviation from the norm. (In fact, the further one gets from the market benchmark, the better performance is likely to be, according to studies on active share.) If any benchmark is used at all, maybe it should be related to the wealth levels of the peer group to motivate the client to strive for higher status and greater wealth.
I’m sure there is a lot more to be gleaned from this paper and I’m looking forward to having time to read it again.
