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


When it comes to investment models and theories of how marketswork, convenience usually trumps reality. The simple fact is thatmany revered investment theories and market models are flatlywrong—that is, if we insist that they work in the real world.Unfounded assumptions, erroneous theories, unrealistic models,cognitive biases, emotional foibles, and unsubstantiated beliefsall combine to lead investors astray—professionals as well asnovices.

In this engaging new book, Jack ...

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

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When it comes to investment models and theories of how marketswork, convenience usually trumps reality. The simple fact is thatmany revered investment theories and market models are flatlywrong—that is, if we insist that they work in the real world.Unfounded assumptions, erroneous theories, unrealistic models,cognitive biases, emotional foibles, and unsubstantiated beliefsall combine to lead investors astray—professionals as well asnovices.

In this engaging new book, Jack Schwager, bestselling author of theMarket Wizards series, takes aim at some of the mostpervasive market precepts, money management misconceptions, andirrational investor behaviors. From the theory of efficient marketsto buying in up markets and selling in down markets, Schwager turnseach misguided idea on its head, one at a time. Supported by awealth of well-documented historical evidence and a healthy dose ofcommon sense, he exposes the truth about the cherished assumptionsand fallacious thinking at the core of some of the most respectedinvestment theories and models and explores many common investorerrors. In this book, you'll discover why:

  • Expert opinion is NOT more reliable than the proverbialdart-throwing chimp
  • The markets are NOT efficient
  • Low volatility does NOT necessarily imply low risk, and highvolatility does NOT necessarily imply high risk
  • Market prices are NOT normally distributed
  • Investing in equities when markets are doing well is NOTconducive to achieving above-average returns
  • Concentrating on funds with the strongest record of returns isNOT a sound strategy
  • Past returns are NOT a reliable indicator of futureperformance
  • A hedge fund portfolio strategy is NOT riskier than atraditional portfolio approach
  • VaR does NOT provide a good indication of worst-case risk
  • Superior performance does NOT necessarily imply managerskill

But Schwager does much more than simply burst bubbles; he offersa sobering draught of real-world investment insight and guidancespanning both traditional and alternative investment classes.Drawing upon his years as an asset manager and trader, he sharespriceless lessons on an array of investing topics, both basic andadvanced, including portfolio management, risk assessment,investment selection, hedge fund investing, investment timing, andmuch more.

Market Sense and Nonsense is an indispensable source ofreal-world market wisdom and investing know-how for investors ofevery ilk.

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Product Details

  • ISBN-13: 9781118494561
  • Publisher: Wiley
  • Publication date: 11/6/2012
  • Edition number: 1
  • Pages: 368
  • Sales rank: 767,268
  • Product dimensions: 6.10 (w) x 9.10 (h) x 1.40 (d)

Meet the Author

JACK D. SCHWAGER is a recognized industry expert onfutures and hedge funds and the author of the widely acclaimedMarket Wizards and Schwager on Futures book series.He is currently the co-portfolio manager for the ADM InvestorServices Diversified Strategies Fund, a portfolio of futures and FXmanaged accounts. He is also an advisor to Marketopper, anIndia-based quantitative trading firm. Previously, Mr. Schwager wasa partner in the Fortune Group, a London-based hedge fund advisoryfirm, which specialized in creating customized hedge fundportfolios for institutional clients, and also spent over twentyyears as a director of futures research for some of Wall Street'sleading firms.

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Table of Contents

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 Moves27

Price Moves Determine Financial News 37

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

The Flawed Premise of the Efficient Market Hypothesis: A ChessAnalogy 40

Some Players Are Not Even Trying to Win 42

The Missing Ingredient 44

Right for the Wrong Reason: Why Markets Are Difficult to Beat47

Diagnosing the Flaws of the Efficient Market Hypothesis 49

Why the Efficient Market Hypothesis Is Destined for the Dustbinof Economic Theory 50

Investment Insights 52

Chapter 3 The Tyranny of Past Returns 55

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

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

Is There a Benefit in Selecting the Best Sector? 63

Hedge Funds: Relative Performance of the Past Highest-ReturnStrategy 70

Why Do Past High-Return Sectors and Strategy Styles Perform SoPoorly? 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 Matters107

Investment Insights 109

Chapter 5 Why Volatility Is Not Just about Risk, and the Caseof 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 Statistics133

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 Reality211

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 Human223

A Parable 223

Fear of Hedge Funds 225

Chapter 14 The Paradox of Hedge Fund of FundsUnderperformance 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 Alternativeto Funds 247

The Essential Difference between Managed Accounts and Funds248

The Major Advantages of a Managed Account 249

Individual Managed Accounts versus Indirect Managed AccountInvestment 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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