The title of this book made me genuinely curious. As I flipped through the few chapters, I am attracted by the tons of investment misconceptions. Some good examples are listed below:
People are risk averse when it comes to gain, but are risk takers when it comes to avoiding a loss. It explains why traders tend to let their losses run and cut their profits short.
Bankrupt stocks continue to trade at some level meaningfully above zero for quite some time before finally fading into oblivion. Why? Because even though the likelihood of the stock eventually going to zero is virtually 100%, people will rationalize: "I bought it at $30 and it is down to $1. I have already lost $29, and the worst case is only a $30 loss. I might as well take a chance." People are risk takers when it comes to trying to avoid a total loss, a fact that explains a lot of market behavior.
In a chess tournament, all the players know the same rules and have access to the same chess books and records of past games by world champion, yet only a small minority excel. There is no reason to assume that all players will use the same information with equal effectiveness. Why should the market, which in sense represent an even more complex game than chess (there are more variables, and the rules are always changing) be any different?
Some market participants, however, are not seeking to maximize profits, but are operating on different agendas. We consider two such classes of market participants: hedgers and government.
Although it is open possible to identify when the market is in a euphoric or panic state, it is the difficulty in assessing how far bubbles and panics will carry that makes it so hard to beat the market. One can be absolutely correct in assessing a fair value for market, but lose heavily by taking a position too early.
The best prospective years for realizing above average equity returns are those that follow low-return periods. Years following high-return periods, which are the times most people are inclined to invest, tend to do slightly worse than average on balance.
The reason why risk assessments based on the past track record so often prove to be fatally flawed is that they are based only on visible risk - that is losses and volatility evident in the track record - and do not account for hidden risks - that is, sporadic event-based risks that failed to be manifested during the track record period.
Good performance is not necessarily a positive attribute. Sometimes superior past performance may reflect the willingness to take on greater risk rather than manager skill.
It should be noted that because of their much more greater high frequency of trading, hedge funds account for a much larger portion of each market's trading activities. Big fish can do very well in a small pond, but if there are too many of them, they will starve. So, the advice that investors should include hedge fund allocations in their portfolios will remain valid, as long as this advice does not become too popular.
Investors always seem to ask hedge funds the question: How much leverage do you use? This question is flawed on two fundamental grounds. First, the question is meaningless, given that it ignores units of measurement: the underlying investment (that is, what is being leveraged). Second, it implicitly assumes that there is a direct connection between leverage and risk. Not only is this assumption false, but it is even possible - in fact, entirely common - for a higher-leveraged investment to have low risk.
A maximum leverage constraint applied uniformly to all prospective investments regardless of portfolio content is analogous to a traffic law that applies a 40 miles per hour speed limit to all roads, in all conditions.
Increasing leverage can increase risk if leverage is used to increase net exposure to the market. If, however, leverage is used for hedging to reduce the portfolio's next exposure, then it actually reduce risk.
Although leverage can be dangerous, the knee-jerk reaction many investors have to leverage can lead to nonsensical investment biases. Investors need to focus on risk, not leverage.
There is a common belief that hedge fund managers will object to managed accounts because they will be concerned about the confidentiality of their positions. This perception is based on faulty logic. How many hedge fund managers don't have a prime broker? Presumably zero.
A portfolio with a small number of uncorrelated holdings is effectively more diversified than a portfolio with a large number of significantly correlated assets.
With such a long list of great examples, this book must be super good to me? The answer is no. As I mentioned above, I was misled by the topic of this book. I thought it is a pure rational versus irrational stuff in regards to financial markets. Ended up, I think the author mainly focus on investing in hedge funds. This is the main thing that disappointed me at the end. After finished the book, I have a weird feeling that the author is pushing hard for hedge fund in general and fund of funds in particular.
Overall, this is still a nice book to explore. At least, the 55 investments misconceptions will get readers to think (think hard) and there are definitely certain values behind it. As such, for a full rating of 10, I am going to rate it at 8. Frankly, I prefer Jack D. Schwager's other books...
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