Market Sense and Nonsense
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1 Market Sense and Nonsense How the Markets Really Work (And How They Don't) Jack D. Schwager WILEY John Wiley & Sons, Inc.
2 Contents Foreword Prologue XV xvii Part One Markets, Return, and Risk Chapter 1 Chapter 2 Expert Advice Comedy Central versus CNBC The Elves Index Paid Advice The Deficient Market Hypothesis The Efficient Market Hypothesis and Empirical Evidence The Price Is Not Always Bight The Market Is Collapsing; Where Is the News? The Disconnect between Fundamental Developments and Price Moves Price Moves Determine Financial News IX
3 X CONTENTS 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 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...? 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
4 Contents xi 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 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 Chapter 7 Sense and Nonsense about Pro Forma Statistics Chapter 8 How to Evaluate Past Performance 137 Why Return Alone Is Meaningless 137 Risk-Adjusted Return Measures 142 Visual Performance Evaluation Chapter 9 Correlation: Facts and Fallacies 169 Correlation Defined 169 Correlation Shows Linear Relationships 170 The Coefficient of Determination (r 2 ) 171 Spurious (Nonsense) Correlations 171 Misconceptions about Correlation 173 Focusing on the Down Months 176 Correlation versus Beta Part Two Hedge Funds as an Investment Chapter 10 The Origin of Hedge Funds 185 Chapter 11 Hedge Funds Differences between Hedge Funds and Mutual Funds 196
5 Xll Chapter 12 Chapter 13 Chapter 14 Chapter 15 CONTENTS Types of Hedge Funds Correlation with Equities Hedge Fund Investing: Perception and Reality The Rationale for Hedge Fund Investment Advantages of Incorporating Hedge Funds in a Portfolio The Special Case of Managed Futures Single-Fund Risk - Fear of Hedge Funds: It's Only Human A Parable Fear of Hedge Funds The Paradox of Hedge Fund of Funds Underperformance The Leverage Fallacy The Folly of Arbitrary Investment Rules Leverage and Investor Preference When Leverage Is Dangerous 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
6 Contents xiii Evaluating Four Common Objections to Managed Accounts 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 Chapter 18 Diversification: When More Is Less Chapter 19 Robin Hood Investing 283 A New Test 286 Why Rebalancing Works 290 A Clarification Chapter 20 Is High Volatility Always Bad? Chapter 21 Portfolio Construction Principles 301 The Problem with Portfolio Optimization 301 Eight Principles of Portfolio Construction 305 Correlation Matrix 309 Going Beyond Correlation
7 XIV CONTENTS 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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