Review of Finding Alpha: The Search for Alpha When Risk and Return Break Down (Wiley Finance) (Hardcover)

What I like about this book:

*It contains important new ideas that can help any risk-taker with quantitative skills succeed
*It challenges conventional wisdom
*The meat of the book is based on practical experience, not just things that seem right to the author, but things he has tried, and generally with success

What I don't like about this book:

*$95, this should be a $25 list book available for $15 on Amazon and $9.99 Kindle
*Sloppy argument and editing, to the point that some passages are not intelligible (doubly annoying in view of the first criticism)
*Lack of appreciation for other people's thought, which leads to missing useful links

An example of the sloppiness (and there are many) is on page 21, "The key to the portfolio approach is the variance of two random variables is less than the sum of their variance." This makes no sense. He might mean "The variance of THE SUM of two random variables is less than the sum of their varianceS," but this is true only if their covariance is negative, while portfolio theory is more concerned with the positive covariance case. If the variables are uncorrelated, the variance of the sum is equal to the sum of the variances.

He might mean, "The STANDARD DEVIATION of THE SUM of two random variables is less than OR EQUAL TO the sum of their STANDARD DEVIATIONS," which is true, but a stretch from the original. Confusing variance and standard deviation is not something a quant is likely to do. Things like this destroy the value of the book for most people. Readers not confident of their quantitative skills will likely give up and figure the book is too hard (or worse, believe something false). Remaining readers will probably stop after the third or fourth example, figuring the author doesn't understand what he's writing about. Even those who continue on have lost whatever thought the author was trying to express. This stuff is hard enough even when expressed clearly and precisely.

The book's summary of quantitative finance is backed up by lots of references, but I would bet that the author has not read all the references. He doesn't even seem to be familiar with Hyman Minksky's work, and he was a graduate assistant for Minsky. Nassim Taleb is not cited and he has a best-seller that covers some of the same ground.

Unlike most people who dismiss the achievements of academic quantitative finance, the author does not concentrate on how unlikely the assumptions of the models are, instead he deconstructs the equations. But the point of the research is not the equation, it's the identification of the variables, the supporting argument and the empirical evidence. Financial equations are usually trivially simple, but that's not the same as obvious or useless.

For example, the Capital Asset Pricing Model, which is the major target of the book, is a relation between immediate horizon ex ante expected returns of securities. The author assumes that this is a natural and obvious way to think about markets and valuation, then criticizes the equation. But there are lots of other potential ways to frame the issue: prices, values, cash flows, long-term returns, ex post returns and others. And "expected return" only makes sense in a rigorous context (who does the "expecting," and when?). The author scorns rigor, but then uses the concept of expected return in a model with divergent expectations among investors, without discussion of whose beliefs define the expected return, and fails to distinguish that concept clearly from ex post average return and market-clearing return. He would probably call these questions "hair-splitting," as he does to similar objections in the book, but without answers his ideas don't make sense. Nowhere in the book does the author discuss time horizons, everything is stated in terms of a single one-year period. His theory requires that investors pay for risk, but he doesn't consider that risk can be created free (two risk-lovers can flip a coin for money or, more realistically, zero-sum securities can be created with offsetting risk). Why would something that can be created free have a positive price in the market?

However obvious the equations are now, people believed different things in the past, and acted on them. It was only after years of gathering empirical evidence and debating opposing views that the ideas changed practice. More importantly, it is only with this precision and data that the anomalies the author builds his theory on were revealed. No one ever discovered an anomaly without starting from the standard theory, without a standard there are no anomalies. The author implies repeatedly that academic finance ignores or explains away these anomalies when, in fact, they are the focus of research and other people have advanced explanations similar to his, and more radical ones as well. The author has seen far because he stood on the shoulders of giants, but he calls them midgets and tells the world he did it in spite of them.

Okay, with all that, why should you read this book? Because when the author stops his sloppy and foolish top-down theorizing and begins to reason bottom-up from what he knows, he has some brilliant, incisive and useful points. He describes the multiple facets of risk in a new way. It combines ideas from probability theory, behavioral theory and economics, but has a unique structure. It might be a brilliant theoretical advance, I'm not sure, but it is definitely an actionable view. This is risk that makes sense in the trenches. It is pragmatic and will not lead you into silly errors, as almost all other versions of risk can do (of course, some but unfortunately not all of the people who use these other ideas know that, and emphasize that you have to use them with care). This is risk defined for risk-takers.

For one example, and there are many, more than the examples of sloppiness, the book discusses Sharpe ratios on page 245-55 in a quantitatively reasonable way. This is very rare. Or a gem from page 177, "The list of good alpha ideas is highly parochial in practice because a good idea is an improvement on the state of the art, which is peculiar to a specific art." If this seems obvious to you, you are probably a risk-taker, and will find lots of good quantitative analysis in this book. If this does not seem obvious but you got as far as page 177, you are probably a quant who needs risk-taking explained in blunt terms. Both of you will find great value in this book.

The most important single insight is that alpha is not a discovery, but an invention. It's not something you get rich just for finding, it's something you seek because it's an opportunity to invent your way to wealth. Alpha is not a block of gold lying in the street, it's noticing that in some niche, you're a sighted person in the valley of the blind. You are good at telling the difference between good and bad positions of a certain kind, and not enough other people are equally good or better to remove the profit opportunities. Finding this alpha is only step one, you have to work at mining it. Alpha shows you how to mine in a good place (for you), not a played out shaft.

This idea is integrated into a reasonably complete financial theory. The foundation seems solid but, as described above, its superstructure is jumbled and ugly. Also, it has only been subjected to limited testing, so you try it at your own risk. It could change radically or even evaporate as people other than the author attempt to apply it with different skill sets and opportunities. For all of that, this is essentially reading for quantitatively-inclined risk takers.



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