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Market Sense and Nonsense


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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 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

About the Author

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.


'Everybody, and I mean everybody who has an investment portfolio will profit from reading this book...kudos to the author for offering the investing world an uncommonly worthwhile book.' (, 12th Novemebr 2012) '...Mr Schwager's book starts off with plenty of sound, basic advice... before expertly demonstrating that a leveraged exchange traded fund is a dreadful investment because of its structure, being almost bound to disappoint' (The Economist, January 2013) 'Full of common sense' (Pensions World, February 2013)

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