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Tuesday, January 22, 2013

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

When it comes to the markets, academics, professionals and novice investors have one thing in common: They all operate on assumptions that fail to hold up in the harsh light of reality. The following are a sampling of observations about how markets really work:
  1. The market is not always right. The best opportunities arise when the market is most wrong.
  2. Big price moves begin on fundamentals but end on emotion.
  3. Past returns are not future returns. Past returns can be very misleading if there are reasons to believe that future market conditions are likely to be significantly different from those that shaped past returns.
  4. The best-performing past investments often do worse than the worst-performing past investments in the future--and the future after all is where we all have to make our investment decisions.
  5. The best time to initiate long-term investments in equities is after extended periods of underperformance.
  6. Faulty risk measurement is worse than no risk measurement at all because it will lull investors into unwarranted complacency.
  7. Volatility is frequently a poor proxy for risk. Many low volatility investments have high risk, while some high volatility investments have well-controlled risk.
  8. The real risks are often invisible in the track record.
  9. High past returns sometimes reflect excessive risk-taking in a favorable market environment rather than manager skill.
  10. Return alone is a meaningless statistic because return can always be increased by increasing risk. Return/risk should be the primary performance metric.
  11. Leverage alone tells you nothing about risk. Risk is a function of both the underlying portfolio and leverage. Leveraged portfolios can often be lower risk than unleveraged portfolios--it depends on the assets in the portfolio.
Jack D. Schwager   

Jack D. Schwager

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