Schwager - Market sense and nonsense how the markets really work (and how they dont)

Contents

Other Books by Jack D. Schwager

Cover design: John Wiley & Sons, Inc.

Copyright 2013 by Jack D. Schwager. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com . Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions .

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com . For more information about Wiley products, visit www.wiley.com .

Library of Congress Cataloging-in-Publication Data

Schwager, Jack D., 1948

Market sense and nonsense : how the markets really work (and how they dont) / Jack D. Schwager.

p. cm.

Includes index.

ISBN 978-1-118-49456-1 (cloth); 978-1-118-50934-0 (ebk); 978-1-118-50943-2 (ebk); 978-1-118-52316-2 (ebk)

1. Investment analysis. 2. Risk management. 3. Investments. I. Title.

HG4529.S387 2013

332.6dc23

2012030901

No matter how hard you throw a dead fish in the water, it still wont swim .

Congolese proverb

With love to my children and our times together:

To Daniel and whitewater rafting in Maine (although I could do without the emergency room visit next time)

To Zachary and the Costa Rican rainforest, crater hole roads, and the march of the crabs

To Samantha and the hills and restaurants of Lugano on a special weekend

I hope these memories make you smile as much as they do me .

With love to my wife, Jo Ann, for so many shared times: 5,000 BTU 2, cashless honeymoon, Thanksgiving snow in Bolton, Minnewaska and Mohonk, Mexican volcanoes, the Mettlehorn, wheeling in Nova Scotia and PEI, weekends at our Geissler retreat, the Escarpment, Big Indian, Yellowstone in winter, Long Point and Net Result .

Foreword

I was initially flattered when Jack asked me to consider writing the Foreword for his new book. So, at this point, it seems ungrateful for me to start off with a complaint. But here goes. I wish Jack had written this book sooner.

It would have been great to have had it as a resource when I was in MBA school back in the late 1970s. There, I was learning things about the efficient market theory (things that are still taught in MBA school to this day) that made absolutely no sense to me. Well, at least they made no sense if I opened my eyes and observed how the real world appeared to work outside of my business school classroom. I sure wish that back then Id had Jacks simple, commonsense explanation and refutation of efficient markets laid out right in front of me to help direct my studies and to put my mind at ease.

It would have been nice as a young portfolio manager to have a better understanding of how to think about portfolio risk in a framework that considered all different aspects of risk, not just the narrow framework that I had been taught in school or the one I used intuitively (a combination of fear of loss and hoping for the best).

I wish Id had this book to give to my clients to help them judge me and their other managers not just by recent returns, or volatility, or correlation, or drawdowns, or outperformance, but by a longer perspective and deeper understanding of all of those concepts.

I wish, as a business school professor, I could have given this book to my MBA students so that the myths and misinformation they had already been taught or read about could be debunked before institutionalized nonsense and fuzzy thinking set them on the wrong path.

I wish Id had this book to help me on all the investment committees Ive sat on over the years. How to think about short-term track records, long-term track records, risk metrics, correlations, benchmarks, indexes, and portfolio management certainly would have come in handy! (Jack, where were you?)

Perhaps, most important, for friends and family it would have been great to hand them this book to help them gain the lifelong benefits of understanding how the markets really work (and how they dont).

So, thanks to Jack for writing this incredibly simple, clear, and commonsense guide to the market. Better late than never. I will recommend it to everyone I know. Market Sense and Nonsense is now required reading for every investor (and the sooner they read it, the better).

Joel Greenblatt

August 2012

Prologue

Many years ago when I worked as a research director for one of the major Wall Street brokerage firms, one of my job responsibilities included evaluating commodity trading advisors (CTAs). One of the statistics that CTAs were required by the regulatory authorities to report was the percentage of client accounts that closed with a profit. I made the striking discovery that the majority of closed accounts showed a net loss for virtually all the CTAs I reviewedeven those who had no losing years! The obvious implication was that investors were so bad in timing their investment entries and exits that most of them lost money even when they chose a consistently winning CTA! This poor timing reflects the common investor tendency to commit to an investment after it has done well and to liquidate an investment after it has done poorly. Although these types of investment decisions may sound perfectly natural, even instinctive, they are also generally wrong.