Sort of. “Risk-free” always has to be defined relative to some baseline level of performance. You’d think that “hiding dollars in your mattress” would be risk-free (as long as you don’t get robbed), because the value of your “investment”, measured in dollars, won’t go down. On the other hand, what if you stuffed your mattress with euros instead of dollars? Now the value of your investment, as measured in euros, won’t change, but the value of your investment, measured in dollars, can. (And you could also measure the value of your investment in terms of its ability to buy ounces of gold, bushels of wheat, barrels of oil, McDonalds hamburgers, Google shares, kilowatt-hours of electricity, or even hours of human labor.)
Normally, people who study investing assume that people care about “absolute wealth” and use either dollars or U.S. treasury bills as their “risk-free” benchmark, but Falkenstein is saying that this doesn’t reflect the actual behavior of the people who manage most of the money in the economy. Falkenstein says that they act as though they care not about “absolute wealth” but “relative wealth”: their performance compared to other investors. After all, if everybody lost a lot of money, it’s clearly not your fault the fund lost all that value, so you get to keep your job. And even if you’re making money, you’ll lose clients if other people happen to be making a lot more. Basically, only deviations from average market returns (as measured by the S&P 500) are rewarded or punished, so the “risk-free” thing for them to do is to act like an index fund and end up with exactly “average” returns.
I wouldn’t say “for him”; he advises people to choose a low beta portfolio, but yes, in the model he uses to explain the data investing in the market portfolio is risk free.
I would say ‘for him’ because ‘Falkenstein risk-free’ <> ‘risk-free’ as is commonly used. (For example, anyone invested in the whole market the last few years knows that it’s not risk-free in the literal or commonly used sense.) As a result, ‘Falkenstein risk premium’ <> ‘risk premium’ as commonly used.
I think if he had used a different term, like baseline or benchmark for example (instead of recycling/ humptifying the existing term ‘risk free’) his article would be clearer.
Falkenstein violates the second of what I think of as the Two Commandments of Research:
If a name for a concept exists in the literature, you use it; you don’t create your own name for a concept that’s already in currency. If your concept is one-off (i.e., related, but somehow different) from an existing concept, it’s best to coin a term which is a modification of the current term.
Thou shalt never clobber an existing term by giving it a new meaning different from its existing meaning. Ever.
Falkenstein seems to change the definition of ‘risk-free’; for him, risk-free means investing in the whole market?
Sort of. “Risk-free” always has to be defined relative to some baseline level of performance. You’d think that “hiding dollars in your mattress” would be risk-free (as long as you don’t get robbed), because the value of your “investment”, measured in dollars, won’t go down. On the other hand, what if you stuffed your mattress with euros instead of dollars? Now the value of your investment, as measured in euros, won’t change, but the value of your investment, measured in dollars, can. (And you could also measure the value of your investment in terms of its ability to buy ounces of gold, bushels of wheat, barrels of oil, McDonalds hamburgers, Google shares, kilowatt-hours of electricity, or even hours of human labor.)
Normally, people who study investing assume that people care about “absolute wealth” and use either dollars or U.S. treasury bills as their “risk-free” benchmark, but Falkenstein is saying that this doesn’t reflect the actual behavior of the people who manage most of the money in the economy. Falkenstein says that they act as though they care not about “absolute wealth” but “relative wealth”: their performance compared to other investors. After all, if everybody lost a lot of money, it’s clearly not your fault the fund lost all that value, so you get to keep your job. And even if you’re making money, you’ll lose clients if other people happen to be making a lot more. Basically, only deviations from average market returns (as measured by the S&P 500) are rewarded or punished, so the “risk-free” thing for them to do is to act like an index fund and end up with exactly “average” returns.
I wouldn’t say “for him”; he advises people to choose a low beta portfolio, but yes, in the model he uses to explain the data investing in the market portfolio is risk free.
I would say ‘for him’ because ‘Falkenstein risk-free’ <> ‘risk-free’ as is commonly used. (For example, anyone invested in the whole market the last few years knows that it’s not risk-free in the literal or commonly used sense.) As a result, ‘Falkenstein risk premium’ <> ‘risk premium’ as commonly used. I think if he had used a different term, like baseline or benchmark for example (instead of recycling/ humptifying the existing term ‘risk free’) his article would be clearer.
Falkenstein violates the second of what I think of as the Two Commandments of Research:
If a name for a concept exists in the literature, you use it; you don’t create your own name for a concept that’s already in currency. If your concept is one-off (i.e., related, but somehow different) from an existing concept, it’s best to coin a term which is a modification of the current term.
Thou shalt never clobber an existing term by giving it a new meaning different from its existing meaning. Ever.
Should you still call a triangle a triangle if you’re drawing it on a curved surface?
(You’re right in general, though.)
I suppose extending is a case of “giving it a new meaning different from its existing meaning”, but it isn’t clobbering.