Blog Profile: Falkenblog, Making sense of Risk

A former hedge fund manager who hasn’t been able to work due to his former employer, Telluride Asset Management in Minneapolis, suing him for stealing the firm’s trade secrets and violating its confidentiality agreement. Falkenstein had created trading algorithms for Telluride during his two and a half years on the job there, and the firm believed he was planning to use the same techniques to trade stocks for a fund he wanted to establish.  Hence instead, Eric Falkenstein has been devoting time to his blogging and research.

Amongst his research, I found the most interesting one being the one on risk. In his article “Why Take Risk?” he discusses that risking taking in general taking in general is not compensated.  He notes that:

A lot of people would be willing to put their funds in some blind risky trust at a young age, if they could then know with statistical certainty this would maximize their wealth at retirement. If this were so investing would be a lot simpler. Also, think about other distasteful activities, such as cleaning septic tanks. Indeed, Keynes compared risk taking to working in ‘smelly’ occupations, noting such activity would require a premium. Yet septic tank work does not pay really well, and the Untouchables in India have long had a monopoly on cleaning sewers manually without much compensation.

He goes on to explain that this is due to the fact that males tend to take more risks because they have to impregnate females, whilst females more often than not wait around to be impregnated.   In addition he says that:

Modern finance is profoundly misleading when it suggests that reward is merely a function of our ability to withstand some abstruse risk (ie, the covariance with the as-yet-unidentified stochastic discount factor), and chance. Skill, effort, and learning play no part in this sterile world. In contrast, people should see risk taking as a process of self-discovery, of becoming the best you can be, and that playing it safe is, for males at least, a path of oblivion. The payoffs to risk-taking are partially chance, but if you want to take risks intelligently you will gravitate towards risks consistent with your skills, and get better and better at them. If some risk demands nothing of you, merely jumping at it is surely foolhardy because risks do not generate higher-than-average-returns as a general rule, and suggests whoever is selling this opportunity is a modern snake-oil salesman.

Elsewhere, he also posts videos about his findings and linked another research paper which has also found that lower risk instruments gave better risk adjusted returns.  Separately, he has also explains that the black scholes models is faulty because as it assumes constant volatility, Econometrics are faulty because of omitted variable bias and that most of these variables are non-linear,  and that higher volatility does not equate to higher risk.  Lastly, he also gives examples of alpha deception, where people people overstate their ability to generate excess returns for their clients.  He uses the recent indictment of Goldman Sachs as an example of such a case.  He also highlights how BBB products were structured into AAA securities.


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