Instead of Finding Alpha, Falkenstein’s book ought to be called Killing Beta. The central tenet of the book is that more risk does not beget more return. Specifically, Falkenstein argues that the Capital Asset Pricing Model (CAPM) and its intellectual descendants – Arbitrage Pricing Theory and the Stochastic Discount Factor – are wrong. Not incomplete, but simply wrong. Needless to say, this flies in the face of most of financial academia, though many of the ideas have now gained acceptance among practitioners.
Falkenstein traces the history of the CAPM, outlining the intellectual milieu that produced it (the “Physics envy” of post-Samuelson economics) and the early empirical results that seemed to support it. Having trained under some of the finest financial economists of his generation, Falkenstein can hardly be accused of misunderstanding the subject matter; his explanations and derivations of the CAPM and APT are first-rate. He takes a highly methodical approach to analyse the assumptions on which these theories rest, then, with a Feynman quote as a North star, he proceeds to dismantle the CAPM: “It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong”.
What distinguishes Falkenstein’s critique from other anti-establishment thinkers (such as the Mandelbrots and Talebs of the world) is that he provides a competing theory – in the words of Andrew Lo, “it takes a theory to beat a theory”. His core postulate is that investors care not about absolute risk, but relative risk; the nightmare scenario for an investor is to lose money while their neighbour is making money. With this one simple statement, which seems at least as plausible as the “absolute concave utility” assumption of the CAPM, risk premia evaporate, and beta along with it. As with Einstein’s relativity, from a simple new postulate springs a theory which explains the facts better than the current paradigm.
Finding Alpha is an intellectual treat and an excellent antidote to academic dogma (not just financial). Falkenstein meanders widely through epistemology, the history of science, and his own personal experiences of academia. This perhaps makes the book tough to recommend to a specific audience. But if we adopt an information theory mindset, information is really a measure of surprise – unexpectedness relative to the prior distribution. In that regard, Finding Alpha is a deeply informative gem that seems to have received far less attention than it deserves.