Market Sense and Nonsense

Book by Jack Schwager

Article and Review by GlobalMacroForex

Jack Schwager is well known for interviewing famous and successful hedge fund managers and summarizing their insights.  In his book, he focuses on some of the strategies and insights into the markets that he’s found are work, as well as understanding some common mistakes people make when trying to understand the market.

Let’s dive right in…

Picking investments

Mr. Schwager tells us to never make an investment decision based on past track records without first asking whether there is a reason to assume that the past returns offer some guidance for the future.  This is an important point that George Soros also mentions in his famous quote “I don’t follow the rules, I look for when the rules to game change.”  Being active in asking why is important because it gives insight into when the past will continue by the same sets of rules.

Jack Schwager makes the point that the market is not always right and the best opportunities arise when the market is most wrong.  He says “Big price moves begin on fundamentals but end on emotion”.  Urging the reader to break from the potential short-term hysteria and take a big-picture view that takes the emotions and mood out of it.  Jack Schwager, like the Yoda of trading, tells us “Price movements often cause the news rather than the other way around”.  Again another version of don’t get caught up in the media’s hysteria of the current mood.  Schwager reiterates a similar point as his risk management strategy advising us that past returns are not future returns.  The Future is more likely to be significantly different.

At a major fundamental or psychological transition point, the best past performers often become among the worst future performers.  It’s important to recognize through your trading system when turning points have come and how the market is changing to the new system.  By planning for change, you go against the current mood.   He says the best time to initiate long-term investments in equities is after extended periods of underperformance.  

Risk management

Jack Schwager urges us to focus on the return to risk ratio, not just return pure return.  He teaches us to consider how much gain you are getting for a given amount of risk.  He says we should focus on risk, not just volatility.  Because the real risks are often invisible in the track record, for example, it could be in the fundamentals or the liquidity.  Overall, he concludes “Volatility is frequently a poor proxy for risk”.  He says this because many low-volatility investments have high hidden risks that are invisible on the track record, so volatility is only a good measure of risk for highly liquid investments (when you can quickly get out of it).

Also, this book mentions avoiding leveraged ETFs because they settle daily.  This daily settlement is going to force you to recognize daily losses that you would have avoided having to realize from in a margin leveraged account if the price rebounds.

Asset Allocation by Risk

Schwager teaches us to employ a risk-adjusted allocation process, instead of an equal allocation approach. Instead of just blindly investing X% in foreign equities, X% in domestic equities, instead he suggests breaking the portfolio into risk weights.  Under this type of system, the riskiest investments are the least percentage of the portfolio because you’re allocating assets with a max risk in mind

Mr. Schwager urges readers to diversify well beyond 10 equities because it’s likely that many of them have hidden risk.  However, when employing asset allocation, it’s all about correlation.  How much are these two investments moving together?  If all the investments are highly correlated (fail together) then it is not real diversification. 

If you just do a blind “top-down” allocation process where each category gets a straight percentage then it is likely to underperform due to drawdowns affecting the entire portfolio.  He warns us that “Faulty risk measurement is worse than no risk measurement at all because it will lull investors into unwarranted complacency”.

One piece of advice I found surprising in this book was that leverage doesn’t necessarily mean riskier because it depends on underlying assets.  If for example you have two investments that are highly negatively correlated (one goes up when the other goes down), but you have 100% of the portfolio in the first investment, if you use leverage to also invest in the second investment then you are reducing risk with leverage by having a counteracting position.

Mr. Schwager urges us to take prudent risk management because volatility is detrimental to return due to compounding results.  When you lose a dollar, you are not only losing that dollar, but also all future returns made from the dollar.  Therefore the key is to avoid volatile drawdowns that will reduce the portfolio in the long-term.  He recommends using the log scale for long-term ‘Net Asset Value’ charts so you can see the effects of the compounding return more clearly.

Conclusion

I highly recommend this book as Jack Schwager teaches us some of the common misconceptions and mistakes traders make with the market.   He urges us to avoid emotion and hidden risks in illiquid investments.  Schwager recommends using an asset allocation strategy that allocates based on risk and correlation.  This is so critical because of the compounding returns that would be lost from an upfront drawdown.