Market Sense and Nonsense: How the Markets Really Work

by Jack D. Schwager, Joel Greenblatt (Foreword)

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

Genres: Finance, Economics, Nonfiction, Money, Personal Finance, Business

368 pages, Hardcover

First published October 1, 2012

About the author

Jack Schwager is a recognized industry expert in futures and hedge funds and the author of a number of widely acclaimed financial books. He is currently the co-portfolio manager for the ADM Investor Services Diversified Strategies Fund, a portfolio of futures and FX managed accounts. 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. His prior experience includes 22 years as Director of Futures research for some of Wall Street’s leading firms and 10 years as the co-principal of a CTA.

Mr. Schwager has written extensively on the futures industry and great traders in all financial markets. He is perhaps best known for his best-selling series of interviews with the greatest hedge fund managers of the last two decades: Market Wizards (1989), The New Market Wizards (1992), and Stock Market Wizards (2001). The latest book in the series, Hedge Fund Market Wizards is due to be released in May 2012. Mr 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. He later revised and expanded this original work into the three-volume series, Schwager on Futures, consisting of Fundamental Analysis (1995), Technical Analysis (1996), and Managed Trading (1996). He is also the author of Getting Started in Technical Analysis (1999), part of John Wiley’s popular Getting Started series.

Mr. Schwager is a frequent seminar speaker and has lectured on a range of analytical topics including the characteristics of great traders, investment fallacies, hedge fund portfolios, managed accounts, technical analysis, and trading system evaluation. He holds a BA in Economics from Brooklyn College (1970) and an MA in Economics from Brown University (1971).

Reviews

[Victor · Rating 5 out of 5]

In "Market Sense and Nonsense" author Jack Schwager takes one piece of Wall Street wisdom to task after another. In all he analyzes and overturns 55 common misconceptions about the way markets work. The book is divided into three parts plus an epilogue and two appendices. All tie together pointing the way to better-informed investment strategies.

- Part One lays the groundwork by overturning many common fallacies about the value of expert opinions, past performance metrics, mutual funds and leveraged ETFs. It includes a tour-de-force destruction of the efficient-market hypothesis (the "deficient" hypothesis in Schwager's words) that is by itself worth the price of the book.

- Part Two explores hedge funds in detail starting with their historical development, explains the many different strategies employed, compares hedge funds to mutual funds and managed futures, and evaluates fund-of-fund investment strategies. I found this section surprisingly interesting and practical both as an active trader myself and as a prospective hedge fund investor.

- Part Three looks at portfolios and defines eight principles of portfolio construction with a tilt towards hedge fund investing. Schwager points out that the risk-return profile of hedge funds is superior to mutual funds and, in the form of fund-of-funds, an investment in a hedge fund is actually available to and preferable even for investors of modest means.

- The Epilogue contains 32 useful "investment observations" drawn from the book. Appendix One is an introduction to options as an investment tool. Appendix Two contains mathematical formulas for all of the risk-return metrics used in the book. Some of these are unique tools published here for the first time.

Schwager takes time to explore his subject matter scientifically then draws conclusions based on a strong mix of qualitative and quantitative arguments. Where appropriate he devises tests to model risk-return relationships, then presents the results in the form of crisp charts and tables. Nearly every chapter ends with 1) a summary of the investment misconceptions discovered, 2) a review of the "market reality" versus conventional wisdom, and 3) the "investment insights" or takeaways that may be useful to the reader. For those with limited time, these chapter summaries provide a quick way to skim through the book and capture the highlights.

The foreward is written by Hedge Fund Market Wizard Joel Greenblatt, author of The Little Book That Still Beats the Market (Little Books. Big Profits). Some of the myths that Schwager busts reveal the subtle reasons why Greenblatt's "Magic Formula" investment method reportedly works well over long periods of time.

This book is not an easy read in the manner of Schwager's Market Wizards books. It is a higher-level, more strategic text that covers its financial subject matter in detail and from multiple angles. Yet it is not dry or boring either. Schwager's writing style is interesting and conversational, employs many analogies and examples to convey meaning, and frequently touches on real investor experiences to drive points home. "Market Sense and Nonsense" is aimed at those truly interested in how financial markets work and the reasons why so many commonly-held beliefs do not stand up under rigorous scrutiny. There is more than just investment mythbusting going on here. A thread of clear strategic thinking unifies the entire work.

This book deserves a five star rating. Serious individual investors and speculators, fund managers and CTAs, and even financial markets regulatory personnel may benefit from the insights presented in this book.

[Yousif Al Zeera · Rating 4 out of 5]

Jack Schwager, an American trader born in Antwerp, Belgium, is a recognized industry expert in futures and hedge funds. In this book, he covers a wide range of investment insights and strategies; and in the process, dusts 55 investment misconceptions in the dust bin. Things related to hedge funds, portfolio allocation, standard deviation, equal weighting, measuring risk, risk/return metric, diversification over 10, standalone vs portfolio analysis, correlations, efficient market and much more. Anyone making investments personally or managing investments professionally would hugely benefit from this book.

[Hanyu · Rating 5 out of 5]

I like the data and examples to support each point. To some people's criticism, my view on books like this is not to take it purely on its face value but rather see them as tools to provoke your own thought process.

[InvestingByTheBooks.com · Rating 3 out of 5]

I was excited when I first heard about this book. This is for two reasons. A new book from Jack Schwager is always something to look forward to. He has done the Investment Management industry tremendous service through his educational and entertaining in-depth interviews with knowledgeable, passionate money managers. These interviews make it obvious to me, that the market is not efficient if you have a well thought-out investment philosophy, a coherent process, strong work ethics and discipline. Second, the book’s title made me genuinely curious. The market is flooded with industry-specific aphorisms or “market truths”, some more commonsensical than others, although together far too often contradictory and quite commonly derived from the “good old days”. How do they stand up to a reality test in today’s highly competitive market? Few are more appropriate for this kind of analysis than Schwager.

The essence of the book is 55 “Investment Misconceptions” where Schwager tells us what reality is. Some stated misconceptions are quite obvious to the experienced investor, e.g. “The average investor can benefit from listening to the recommendations made by financial experts” and others are truly intriguing, e.g. “The diversification benefits beyond 10 holdings are minimal” (hint, if you consider worst-case out comes instead of averages, a portfolio of say 20 holdings usually provides substantial additional risk-reduction benefits). Schwager’s “reality-testing” is usually not empirical in an academic sense: rather, it is based on his long experience in analyzing investment managers and their portfolios. But the discussions on the misconceptions are usually straightforward and logical. I doubt an experienced investor would disagree with the conclusions.

The underlying idea behind the book’s theme - to analyze “market truths” and either confirm or falsify them - is brilliant. However, to be honest, I don’t think the outcome of the book is on par with the idea. I wish Schwager had spent more time with this book, focused more on researching trickier “market truths”, e.g. “never catch a falling knife” and analyzed them in greater detail and in a more quantitative way. For example, instead of just listing and discussing hidden risks, he could have tried to quantify their importance and occurrence. It is a bit sad because I believe Schwager, with his potential, had a golden opportunity to write a new Investment Classic with this great idea and missed it. An advanced study of market truths based on market realities and long-term price action instead of theories from academia based on artificial assumptions is still very much in demand. I cannot help being annoyed in my suspicion that Schwager needed to meet a strict deadline or something similar.
The setup of the book is somewhat ad-hoc, too. It consists of three parts: 1) Markets, return and risk, 2) Hedge Funds as an Investment, and 3) Portfolio Matters. The second part doesn’t fully fit with the book’s theme and too much time is spent on the basics of hedge funds, their origin and their differences from mutual funds. The part on hedge funds does have its merits, especially the more advanced chapters, and it could very well have made a book on its own. More focus on the stated purpose would have enhanced my impression of the book.

If I have been too harsh in my critique, it is because of my high expectations of a favorite author. There are several chapters that caught my attention, e.g. I quickly reread the part on Portfolio Matters. I really appreciate Schwager’s thoughts on portfolio rebalancing; they are counterintuitive and probably performance enhancing. Also, almost anyone can learn from Schwager how to evaluate a portfolio manager including assessing his performance and risk taking. The chapter on “Track Record Pitfalls” (hidden risks are far too seldom discussed!) was instructive, as well as the chapter on “The Tyranny of Past Returns”. Further, Schwager’s discussion on sector and hedge fund selection based on past performance is among my preferred readings in this book - a good example of where I believe market convention and “alpha-reality” often differ.

Schwager summarizes his book with 32 Investment Observations. There is lots of market wisdom here to assimilate. Despite some objections to this book, I still regard Schwager to be one of the most able professionals in our industry. I will read his next book, too.

[Jacob · Rating 4 out of 5]

Not exactly what I expected, but it's quite good. This is more a collection of things the author wants to say about markets that go against prevailing "wisdom". It's a bit dry, but Schwager is brief, makes his point, and moves on so it stays interesting. And by "interesting", I mean if you care about reading an argument regarding why hedge funds are less risky than equity funds and moving promptly into a discussion of why leverage doesn't necessarily increase risk. That should tell you almost everything you need to know about whether you want to read this.

For the few of you who are still reading my review, the surprise here is that only a third of the book is about markets and risk (how past returns can be misguiding, mismeasuring risk is worse than not measuring it at all, volatility does not mean what you want it to mean, and the correct uses of correlation). Another third is about hedge funds (how they are often lower risk than equity funds and how managed accounts can be a very consumer-friendly version), and the last third about portfolio building (hint: funds you might select individually may well not work well in a portfolio, and there are good reasons to pick underperforming funds to add to a portfolio). To someone who actively chooses and manages their investments, it's extremely useful. In addition, Schwager's message that you can't use statistics and track records outside of their context is *exactly* what an engineer wants to hear about. Nothing is always a good idea. I need to know why it works, and in what conditions, and what conditions it doesn't work well for!

Bonus: this book has the best takedown of the efficient market hypothesis I've ever seen :)

[Tsuky · Rating 4 out of 5]

You’ll like it if :
- you’re a portfolio manager
- you have loads of money and want to understand how to select a manager to invest your funds
- you’re curious about hedge funds
- you get excited about statistics

A bit dry but I think it’s a solid book and useful reference book.

[Tirath · Rating 1 out of 5]

A supreme rubbish book. It's a book filled with jibber jabber about technicalities in the markets and performances thereof.

Just avoid it.

(It does have a decent cover though).

[Joseph · Rating 3 out of 5]

Some good stuff but also too much self serving propaganda for the hedge fund industry.

[Kiril · Rating 3 out of 5]

I liked the EMH topic, but the rest of the book is extremely dull. The only reason I finished it is because I like the author.

Diagnosing the Flaws of the Efficient Market Hypothesis

We are now in a position to identify the exact points at which the line of reasoning of the efficient market hypothesis is flawed. The efficient market hypothesis can be summarized as follows:

1. The markets incorporate all known information.
2. Therefore prices are always correct.
3. The arrival of new information is random.
4. Changes in prices depend on new information.
5. Therefore you can’t beat the market.
Now let’s consider the validity of each of these five arguments.

1. The markets incorporate all known information.
ASSUME TRUE.
2. Therefore prices are always correct.
FALSE!
Markets are traded by people, not robots, and people often react on emotion more than on information.17 The influence of emotion can cause irrational behavior and result in prices being much too high or low vis-à-vis an objective assessment of the fundamentals.
3. The arrival of new information is random.
ASSUME TRUE
4. Changes in prices depend on new information.
FALSE!
Price moves often lag the information.
Price moves often occur in the absence of new information (e.g., market bubbles and crashes where momentum feeds on itself).
5. Therefore you can’t beat the market.
FALSE!
Prices can be significantly out of line with reasonable valuations.
Prices don’t move in tandem with information.
Some people are more skilled in interpreting information.

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

Supporters of the efficient market hypothesis are reluctant to give up the theory, despite mounting contradictory evidence, because it provides the foundation for a broad range of critical financial applications, including risk assessment, optimal portfolio allocation, and option pricing. The unfortunate fact, however, is that these applications can lead to erroneous conclusions because the underlying assumptions are incorrect. Moreover, the errors will be most extreme in those periods when the cost of errors will be most severe (i.e., market bubbles and panics). In some sense, efficient market hypothesis proponents are like the proverbial man looking for dropped car keys in the parking lot under the lamppost because that is where the light is. The flaws of the efficient market hypothesis are both serious and numerous:

If true, the impossible has happened—and many times! The magnitude of some price moves would be a statistical impossibility if the efficient market hypothesis were true.
Some market participants have achieved track records that would be a statistical impossibility if the efficient market hypothesis were true.
The assumed mechanism for prices adjusting to correct levels is based on a flawed premise, since the price impact of informed traders can be outweighed temporarily by the actions of less knowledgeable traders or by the activity of hedgers and governments, which are motivated by factors other than profit.
Market prices completely out of line with any plausible valuation are a common occurrence.
Price moves often occur well after the fundamental news is widely known.
Everyone having the same information does not imply that everyone will use information with equal efficiency.
The efficient market hypothesis fails to incorporate the impact of human emotions on prices, thereby leaving out a key market price influence that throughout history has at times (e.g., market bubbles and crashes) dominated the influence of fundamental factors.

Investment Misconceptions

Investment Misconception 2: Market prices are perfect and discount all known information.
Reality: Market prices are frequently far removed from any reasonable measure of fair valuation. Sometimes market prices are too high given the prevailing fundamentals; sometimes they are too low.

Investment Misconception 3: Markets can’t be beat.
Reality: Markets are difficult, but not impossible, to beat—a critical distinction that implies that some winners are winners because they are skilled, not because they are lucky (although some winners will merely be lucky). The difficulty in beating the market deceives many people into believing the task is impossible except by luck.

Investment Misconception 4: Price moves are immediate responses to changes in fundamentals.
Reality: Price moves commonly lag changes in fundamentals. Also, sometimes prices are driven by emotional factors rather than fundamentals.

Investment Misconception 5: The assumption of an efficient market model allows historical price changes to be used to derive probability estimates for various size price moves.
Reality: Efficient market–based models implicitly assume price changes are normally distributed—an assumption that will yield reasonably accurate estimates of the probabilities associated with moderate price changes, but will drastically understate the probability of large price changes. The consequences of this deficiency are critical: The risk of a large loss is much greater than implied by conventional risk models based on an efficient market assumption.

[Michael Southall · Rating 5 out of 5]

Don’t get the fairly low avg score this book gets. One of the best ‘pure factual and informative’ and importantly concise (hint: not Benjamin Graham-style) finance book I’ve read (excluding financial scandals and more ‘story-telling’ ones that I really enjoy).

Some reviewers mention about excessive propaganda for the Hedge Fund industry. The only part I would agree is that it does have a fairly heavy focus on hedge funds’ performances but to say that it is propaganda is over the top.

Great read with helpful concise summary notes of key takeaways.

[Andrew Pratley · Rating 4 out of 5]

Very valuable book full of insights that are clearly explained. It has given me much food for thought. I imagine that in future that I will be consulting its pages from time to time. It is not a an easy read. The subject matter will be somewhat dry for some. If, however, you contemplating investing some money then it is a good place if not to start but is certainly worth a visit at the early stages.

[Amanpreet Singh · Rating 2 out of 5]

Had quite different expectations from book reading older market wizards.

This book is more around expalining MF's, Hedgefunds, common fallacies choosing funds.

This book writes against efficient market hypothesis. Okish read, can skip if you have other reads planned. Market wizards are much better.

[Jas · Rating 4 out of 5]

Started a little slow for me. But excellent info about investments. Really helps to understand how hedge investing works. A lot different than the information you might hear from your broker. Good unique information with references, charts, and even the formulas of how things were calculated.

[Paul · Rating 2 out of 5]

Shelved at p94

[Value investor · Rating 3 out of 5]

Insightful and value added. Suitable for beginner who wanted to know more about investing.

[Mrmalibu · Rating 4 out of 5]

Excellent book. Quite heavy to be honest but it was worth the effort.

[Don Macfarlane · Rating 5 out of 5]

Schwager slaughters the so-called Efficient Market Hypothesis that has stultified academic finance deptartments for 40 years. He shows how many of the commonly-used key financial measures of risk are false or misleading and provides superior alternatives. As always Schwager is lucid and objective in presenting the evidence.

[Tom Foreman · Rating 5 out of 5]

Good read from someone that understands how markets really work. And another nail in the coffin of the ridiculous "efficient market" believers rhetoric which is still being pushed by most MBA programs.