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Market Sense and Nonsense: How the Markets Really Work (and How They Don't)


Praise for Market Sense and Nonsense

"This book is a real joy. Smart, clever, funny; deliciously concise. No bull. It tells you what investing is really about, which most certainly isn't what the fakes in the financial services industry, and their paid cheerleaders in the media and academia, want you to think it is about. Mr. Schwager has performed a major service for anyone who ever gets a spare dime to invest and wants to know how to avoid making a mistake. This book is destined to be one of the greatest texts on markets and investing for discussion in schools, universities and barrooms the world over."
--Martin Taylor, Investment Manager, Nevsky Fund PLC

"This is a very ambitious book which succeeds on all counts. It is not a book with just one idea explained repeatedly with different anecdotes. It covers a huge amount of ground across the spectrum of risk and investing, both in theory and in practice. It addresses many of the difficult issues faced by investment professionals today, but written in a way which is designed to be understood by people without a background in investing or finance."
--Colm O'Shea, Founding Partner and CIO, COMAC Capital LLP

"If this book had been available when I started out in the financial markets I would have saved a lot of learning time over the next fifty years. A great guide to understanding how investing and markets really work."
--Edward O. Thorp, author of Beat the Dealer and Beat the Market

"Jack Schwager's new book, Market Sense and Nonsense, deftly addresses a large number of seldomly clarified facts and myths about the investment management business."
--Jaffray Woodriff, cofounder, Chairman, and CEO, Quantitative Investment Management

"If you believe in investigating before you invest, and in knowing what works and what doesn't work, you are likely to do well reading Schwager."
--Ed Seykota

JACK D. SCHWAGER is a recognized industry expert on futures and hedge funds and the author of the widely acclaimed Market Wizards and Schwager on Futures book series. He is currently the co-portfolio manager for the ADM Investor Services Diversified Strategies Fund, a portfolio of futures and FX managed accounts. He is also an advisor to Marketopper, an India-based quantitative trading firm. Previously, Mr. Schwager was a partner in the Fortune Group, a London-based hedge fund advisory firm, which specialized in creating customized hedge fund portfolios for institutional clients, and also spent over twenty years as a director of futures research for some of Wall Street's leading firms.

Foreword xv

Prologue xvii

Part One Markets, Return, and Risk

Chapter 1 Expert Advice 3

Comedy Central versus CNBC 3

The Elves Index 6

Paid Advice 8

Investment Insights 11

Chapter 2 The Deficient Market Hypothesis 13

The Efficient Market Hypothesis and Empirical Evidence 14

The Price Is Not Always Right 15

The Market Is Collapsing; Where Is the News? 24

The Disconnect between Fundamental Developments and Price Moves 27

Price Moves Determine Financial News 37

Is It Luck or Skill? Exhibit A: The Renaissance Medallion Track Record 39

The Flawed Premise of the Efficient Market Hypothesis: A Chess Analogy 40

Some Players Are Not Even Trying to Win 42

The Missing Ingredient 44

Right for the Wrong Reason: Why Markets Are Difficult to Beat 47

Diagnosing the Flaws of the Efficient Market Hypothesis 49

Why the Efficient Market Hypothesis Is Destined for the Dustbin of Economic Theory 50

Investment Insights 52

Chapter 3 The Tyranny of Past Returns 55

S&P Performance in Years Following High- and Low-Return Periods 57

Implications of High- and Low-Return Periods on Longer-Term Investment Horizons 59

Is There a Benefit in Selecting the Best Sector? 63

Hedge Funds: Relative Performance of the Past Highest-Return Strategy 70

Why Do Past High-Return Sectors and Strategy Styles Perform So Poorly? 77

Wait a Minute. Do We Mean to Imply . . . ? 78

Investment Insights 85

Chapter 4 The Mismeasurement of Risk 87

Worse Than Nothing 87

Volatility as a Risk Measure 88

The Source of the Problem 92

Hidden Risk 95

Evaluating Hidden Risk 100

The Confusion between Volatility and Risk 103

The Problem with Value at Risk (VaR) 105

Asset Risk: Why Appearances May Be Deceiving, or Price Matters 107

Investment Insights 109

Chapter 5 Why Volatility Is Not Just about Risk, and the Case of Leveraged ETFs 111

Leveraged ETFs: What You Get May Not Be What You Expect 112

Investment Insights 121

Chapter 6 Track Record Pitfalls 123

Hidden Risk 123

The Data Relevance Pitfall 124

When Good Past Performance Is Bad 126

The Apples-and-Oranges Pitfall 128

Longer Track Records Could Be Less Relevant 129

Investment Insights 132

Chapter 7 Sense and Nonsense about Pro Forma Statistics 133

Investment Insights 136

Chapter 8 How to Evaluate Past Performance 137

Why Return Alone Is Meaningless 137

Risk-Adjusted Return Measures 142

Visual Performance Evaluation 156

Investment Insights 166

Chapter 9 Correlation: Facts and Fallacies 169

Correlation Defined 169

Correlation Shows Linear Relationships 170

The Coefficient of Determination (r2) 171

Spurious (Nonsense) Correlations 171

Misconceptions about Correlation 173

Focusing on the Down Months 176

Correlation versus Beta 179

Investment Insights 182

Part Two Hedge Funds as an Investment

Chapter 10 The Origin of Hedge Funds 185

Chapter 11 Hedge Funds 101 195

Differences between Hedge Funds and Mutual Funds 196

Types of Hedge Funds 200

Correlation with Equities 210

Chapter 12 Hedge Fund Investing: Perception and Reality 211

The Rationale for Hedge Fund Investment 213

Advantages of Incorporating Hedge Funds in a Portfolio 214

The Special Case of Managed Futures 215

Single-Fund Risk 217

Investment Insights 220

Chapter 13 Fear of Hedge Funds: It’s Only Human 223

A Parable 223

Fear of Hedge Funds 225

Chapter 14 The Paradox of Hedge Fund of Funds Underperformance 231

Investment Insights 236

Chapter 15 The Leverage Fallacy 239

The Folly of Arbitrary Investment Rules 241

Leverage and Investor Preference 242

When Leverage Is Dangerous 243

Investment Insights 245

Chapter 16 Managed Accounts: An Investor-Friendly Alternative to Funds 247

The Essential Difference between Managed Accounts and Funds 248

The Major Advantages of a Managed Account 249

Individual Managed Accounts versus Indirect Managed Account Investment 250

Why Would Managers Agree to Managed Accounts? 251

Are There Strategies That Are Not Amenable to Managed Accounts? 253

Evaluating Four Common Objections to Managed Accounts 253

Investment Insights 259

Postscript to Part Two: Are Hedge Fund Returns a Mirage? 261

Part Three Portfolio Matters

Chapter 17 Diversification: Why 10 Is Not Enough 267

The Benefits of Diversification 267

Diversification: How Much Is Enough? 268

Randomness Risk 269

Idiosyncratic Risk 272

A Qualification 273

Investment Insights 274

Chapter 18 Diversification: When More Is Less 277

Investment Insights 281

Chapter 19 Robin Hood Investing 283

A New Test 286

Why Rebalancing Works 290

A Clarification 291

Investment Insights 292

Chapter 20 Is High Volatility Always Bad? 295

Investment Insights 299

Chapter 21 Portfolio Construction Principles 301

The Problem with Portfolio Optimization 301

Eight Principles of Portfolio Construction 305

Correlation Matrix 309

Going Beyond Correlation 310

Investment Insights 314

Epilogue 32 Investment Observations 315

Appendix A Options--Understanding the Basics 319

Appendix B Formulas for Risk-Adjusted Return Measures 323

Sharpe Ratio 323

Sortino Ratio 324

Symmetric Downside-Risk Sharpe Ratio 325

Gain-to-Pain Ratio (GPR) 326

Tail Ratio 326

MAR and Calmar Ratios 326

Return Retracement Ratio 327

Acknowledgments 329

About the Author 331

Index 333