Market Sense and Nonsense: How the Markets Really Work (and How They Don't)

Author: Jack D. Schwager | Categories: Investment Analysis, Risk Management, Hedge Funds, Portfolio Management

Executive Summary

"Market Sense and Nonsense" by Jack D. Schwager, published in 2013 by John Wiley & Sons, is a systematic debunking of widely held investment myths and misconceptions. Schwager, best known as the author of the "Market Wizards" series, brings decades of experience as a fund manager, trading advisor, and researcher to challenge the conventional wisdom that pervades the investment industry. The book covers topics ranging from the efficient market hypothesis and past performance analysis to risk measurement, hedge fund investing, and portfolio construction.

The book's central message is that many of the assumptions underlying mainstream investment practice -- including the reliability of past returns as predictors, the adequacy of volatility as a risk measure, and the efficient market hypothesis itself -- are either wrong or dangerously oversimplified. Schwager combines rigorous analytical thinking with accessible prose, using real-world examples and data to demonstrate why investors consistently make poor decisions and how they can improve. The foreword by Joel Greenblatt underscores the book's practical value for investors at all levels.

Core Thesis & Arguments

Schwager's core argument is that the investment industry is riddled with myths, misapplied theories, and misleading statistics that cause investors to make systematically poor decisions. He identifies several recurring themes: (1) Past returns are the worst predictor of future performance, yet they drive most investment decisions. (2) Volatility is an inadequate and misleading measure of risk. (3) The efficient market hypothesis is theoretically elegant but empirically false. (4) Investors are their own worst enemies, consistently entering at highs and exiting at lows.

Perhaps most provocatively, Schwager demonstrates through CTA data that the majority of investors in consistently profitable funds still lost money, because they entered after strong performance and exited after drawdowns. This finding encapsulates the book's message: even access to excellent investments cannot overcome poor investor behavior and flawed analytical frameworks.

Chapter-by-Chapter Analysis

Prologue

Introduces the stunning finding that most closed accounts at consistently profitable CTAs showed losses, because investors timed their entries and exits poorly. Sets the theme of investor self-sabotage.

Part One: Markets, Return, and Risk

Chapter 1: Expert Advice

Uses Jon Stewart's takedown of CNBC to illustrate the unreliability of expert financial advice. Shows that expert predictions are rarely tracked for accuracy.

Chapter 2: The Deficient Market Hypothesis

A comprehensive critique of the efficient market hypothesis. Argues that while markets are difficult to beat, they are clearly not efficient in the academic sense. The difficulty of beating markets comes from structural factors, not from prices being "right."

Chapter 3: The Tyranny of Past Returns

Demonstrates that the highest-returning investments in one period consistently underperform in the next. Past performance is not merely a weak predictor -- it is often a contra-indicator.

Chapter 4: The Mismeasurement of Risk

Argues that standard risk measures (volatility, VaR) fail to capture the true risks investors face. Introduces the concept of "hidden risk" -- risks that do not appear in historical data but are embedded in a strategy.

Chapter 5: Leveraged ETFs

Explains why leveraged ETFs systematically underperform their stated objectives over longer holding periods due to volatility drag.

Chapters 6-8: Track Record Evaluation

Covers pitfalls in evaluating investment track records, pro forma statistics, and methods for properly assessing past performance using risk-adjusted metrics.

Chapter 9: Correlation -- Facts and Fallacies

Debunks common misconceptions about correlation, including the assumption that low correlation implies diversification benefit in all market conditions.

Part Two: Hedge Funds as an Investment

Chapters 10-16: Hedge Fund Analysis

Covers the origin and mechanics of hedge funds, the paradox of fund-of-funds underperformance, the leverage fallacy, and the advantages of managed accounts over pooled funds.

Part Three: Portfolio Matters

Chapters 17-21: Portfolio Construction

Addresses diversification (why 10 positions is not enough), the rebalancing premium ("Robin Hood investing"), and the counterintuitive role of volatile assets in portfolios. Presents eight principles of portfolio construction.

Epilogue: 32 Investment Observations

A distilled list of the book's key insights, serving as a quick reference for investors.

Key Concepts & Frameworks

• The Tyranny of Past Returns: Top-performing investments in one period systematically underperform in the next, making past returns a contrarian indicator.
• Hidden Risk: The risk embedded in strategies that appears only in extreme conditions and is invisible in historical data (e.g., short-volatility strategies before 2008).
• The Deficient Market Hypothesis: Markets are not efficient but are still hard to beat, for structural rather than informational reasons.
• Robin Hood Investing: Systematic rebalancing "steals" from winners and gives to losers, which counterintuitively improves long-term returns through volatility harvesting.
• Gain-to-Pain Ratio: Schwager's preferred risk-adjusted return metric, which he considers superior to the Sharpe ratio.

Practical Trading Applications

1. Never chase past returns -- the strategy or sector that performed best recently is statistically likely to underperform going forward.
2. Evaluate investments using risk-adjusted metrics (Gain-to-Pain ratio, Sortino ratio) rather than raw returns alone.
3. Look for hidden risks in strategies that show consistently smooth returns -- they may be concealing tail risk.
4. Rebalance portfolios systematically rather than letting winners ride indefinitely.
5. Recognize that your own behavioral tendencies (performance chasing, panic selling) are likely the largest drag on your returns.
6. Maintain deep skepticism toward expert forecasts and financial media prognostications.

Critical Assessment

Strengths: Schwager's analytical rigor is outstanding. The book systematically supports each claim with data and real-world examples. The writing is clear and accessible despite the technical subject matter. The debunking of the efficient market hypothesis is particularly well-argued and balanced.

Weaknesses: Some sections on hedge funds may be less relevant to retail traders. The book is more diagnostic than prescriptive -- it excels at identifying what is wrong with conventional thinking but provides fewer specific solutions. The portfolio construction chapters could benefit from more concrete examples.

Best for: Intermediate to advanced investors and traders who want to develop a more sophisticated understanding of risk, return, and portfolio management. Particularly valuable for anyone allocating capital across multiple strategies or managers.

Key Quotes

"No matter how hard you throw a dead fish in the water, it still won't swim."

"Investors are truly their own worst enemy. The natural instincts of most investors lead them to do exactly the wrong thing with uncanny persistence."

"The simple fact is that many widely held investment models and assumptions are simply wrong -- that is, if we insist they work in the real world."

"Past returns are not merely useless in predicting future performance; they are often misleading."

Conclusion & Recommendation

"Market Sense and Nonsense" is an exceptional book that systematically dismantles the myths and misconceptions that pervade the investment industry. Schwager's combination of rigorous analysis and clear writing makes complex topics accessible without sacrificing intellectual honesty. The book is essential reading for anyone who wants to understand how markets actually work -- as opposed to how academic theory says they should work -- and who wants to avoid the behavioral and analytical traps that cause most investors to underperform. It is one of the most practically useful investment books written in the last two decades.