Jack D. Schwager, author of the Market Wizards series, has done the investor an invaluable service by writing Market Sense and Nonsense: How the Markets Really Work (and How They Don’t) (Wiley, 2013). Everybody, and I mean everybody, who has an investment portfolio will profit from reading this book.
Never again, for instance, will the investor conflate risk with volatility. Never again will she assume that leverage always increases risk. Never again will she chase high-performing funds. Never again will she disregard the benefits of rebalancing. And she might even consider alternative investments, described in the second part of the book: hedge funds and managed accounts.
Schwager’s first target (well, actually, the second—after pointing out the pitfalls of listening to the recommendations of so-called experts) is the “deficient” market hypothesis. Schwager levels argument upon argument to explain “why the efficient market hypothesis is destined for the dustbin of economic theory.” Here he follows Warren Buffett, who once described the efficient market cabal as the equivalent of the “Flat Earth Society” (see Del Vecchio and Jacobs, p. 176). As a corollary to his argument, and one that I bring up in connection with my recent review of Michael Mauboussin’s The Success Equation, Schwager contends that “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).” (p. 52)
Schwager shines brightest, in my opinion, when he parses the distinctions between risk and volatility—and as sub-themes discusses such concepts as VaR and the Sharpe ratio. He dispels two investment misconceptions right out of the gate: that high volatility implies high risk and low volatility implies low risk. “Although it is usually true that high volatility will imply high risk, this assumption will be false for strategies where downside risk is contained and high volatility is due to sporadic large gains.” Think, for instance, of a strategy that buys out-of-the-money options. And “low volatility implies low risk only if the past can be assumed to be a reasonable approximation of the future—an assumption that is frequently unwarranted.” (p. 108) A fund that sells out-of-the-money calls and puts might have experienced very low volatility in a calm market only to be battered if the market moves sharply in either direction.
Correlation, and its mathematical cousin beta, is another concept that is often misunderstood. It is not true, for example, that “investments that are more highly correlated to the market are more likely to decline in bear market months.” (p. 181) Nor is it true that “the higher the correlation between an investment and a market, the more it will be impacted by moves in the market.” (p. 182)
If these claims are not intuitively obvious to you, you owe it to yourself to read Market Sense and Nonsense. The book is written in clear prose with abundant examples so that even a reader with absolutely no statistical background will understand Schwager’s points. And my hunch is that it will shake up a lot of beliefs that even the sophisticated investor and fund manager mistakenly hold. All in all, kudos to the author for offering the investing world an uncommonly worthwhile book.