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

ISBN: 978-1-118-49456-1
368 pages
November 2012
Market Sense and Nonsense: How the Markets Really Work (and How They Don

Bestselling author, Jack Schwager, challenges the assumptions at the core of investment theory and practice and exposes common investor mistakes, missteps, myths, and misreads

When it comes to investment models and theories of how markets work, convenience usually trumps reality. The simple fact is that many revered investment theories and market models are flatly wrong—that is, if we insist that they work in the real world. Unfounded assumptions, erroneous theories, unrealistic models, cognitive biases, emotional foibles, and unsubstantiated beliefs all combine to lead investors astray—professionals as well as novices. In this engaging new book, Jack Schwager, bestselling author of Market Wizards and The New Market Wizards, takes aim at the most perniciously pervasive academic precepts, money management canards, market myths and investor errors. Like so many ducks in a shooting gallery, Schwager picks them off, one at a time, revealing the truth about many of the fallacious assumptions, theories, and beliefs at the core of investment theory and practice.

  • A compilation of the most insidious, fundamental investment errors the author has observed over his long and distinguished career in the markets
  • Brings to light the fallacies underlying many widely held academic precepts, professional money management methodologies, and investment behaviors
  • A sobering dose of real-world insight for investment professionals and a highly readable source of information and guidance for general readers interested in investment, trading, and finance
  • Spans both traditional and alternative investment classes, covering both basic and advanced topics
  • As in his best-selling Market Wizard series, Schwager manages the trick of covering material that is pertinent to professionals, yet writing in a style that is clear and accessible to the layman

 

 

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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

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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.

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November 28, 2012
Jack D. Schwager Has a New Book on the Markets, Focused on the Ways Traders Make Mistakes, Misread Markets, and Fall for Classic Market Mythology

Many investors seek guidance from the advice of financial experts available through both broadcast and print media. Is this advice beneficial?

Jack Schwager, a well-known author, fund manager and an industry expert in futures and hedge funds challenges the assumptions at the core of investment theory and practice and exposes common investor mistakes, missteps, myths, and misreads.

In the book Market Sense and Nonsense: How the Markets Really Work (and How They Don't), Schwager picks them off, one at a time, revealing the truth about many of the fallacious assumptions, theories, and beliefs at the core of investment theory and practice.

The book, published by Wiley includes thirty-two investment observations covering topics on ‘markets, return, and risk’, ‘hedge funds as an investment’ and ‘portfolio matters’.

Schwager has written extensively on the futures industry and great traders in all financial markets. He is best known for his best-selling series of interviews with the greatest hedge fund managers of the past two decades: Market Wizards (1989, new edition 2012), The New Market Wizards (1992), Stock Market Wizards (2001), and Hedge Fund Market Wizards (2012). Schwager’s first book, A Complete Guide to the Futures Markets (1984), is considered to be one of the classic reference works in the field.

Market Sense and Nonsense is a compilation of the most insidious, fundamental investment errors he observed over his long and distinguished career in the markets. It is a highly readable source of information and guidance for general readers interested in investment, trading, and finance.

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