Market Sense and Nonsense
Summary
Jack Schwager, best known for the Market Wizards interview books, wrote this as an attack on beliefs he considers widely held and empirically wrong. Each chapter takes a proposition, states the case for it, and then presents the data against it.
The propositions concern both individual investing and institutional practice. On markets, he disputes that prices are efficient in any strong sense while also disputing that inefficiency makes markets easy to beat. On risk, he argues that volatility and risk are different things, that a track record with low volatility can conceal a large tail exposure, and that the standard measures including the Sharpe ratio mislead when returns are not normally distributed. On hedge funds, he argues that the industry's reported returns are distorted by survivorship and backfill bias, that fund of funds fees rarely justify themselves, and that the diversification benefit hedge funds are bought for disappears in the conditions that make it necessary.
He also treats past performance, arguing that it carries information about manager quality only in combination with an understanding of the strategy, and correlation, arguing that investors use a single number to describe relationships that are not linear and not stable. The book is written for institutional allocators and sophisticated individuals. Its main limitation is that Schwager's alternative recommendations are less rigorous than his criticisms, and readers may finish more sceptical without being better equipped.
Key takeaways 7
- Volatility and risk are different quantities, and strategies that suppress volatility frequently increase the probability of large loss.
- Reported hedge fund index returns overstate the achievable return because of survivorship and backfill bias in the underlying databases.
- Past performance is uninformative unless the observer understands what produced it and whether those conditions persist.
- Correlation is a single number describing a relationship that is neither linear nor stable, and it rises toward one in exactly the conditions where diversification is needed.
- Markets are neither efficient nor easy to beat, and both errors lead to bad allocation decisions.
- The Sharpe ratio penalises upside variance and understates risk in strategies with negatively skewed returns, so it favours option-selling profiles.
- Schwager argues that evaluating a manager requires understanding the source of returns, because performance statistics cannot distinguish skill from a hidden short volatility position.
Who should read it
Allocators and individual investors evaluating managers and strategies who want the standard performance statistics attacked on their own terms.
About Jack D. Schwager
Futures research director and author; co-founder of FundSeeder; creator of the Market Wizards series
The Market Wizards interviews are a primary record of how top traders actually operate, cited across the field.
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