To say the Jack D. Schwager’s series of Market Wizards books have influenced a generation of traders would be a gross understatement. I cited Jack’s original Market Wizards book in my book and mentioned it last year as an influential book on my outlook on the markets. After a bit of a hiatus Schwager is back with a new book Hedge Fund Market Wizards. This series of interviews focuses on managers who have a demonstrated track record of performance based on their ability to generate returns relative to risk. I recently had a chance to send Jack some questions I thought Abnormal Returns’ readers would find of interest. Since Jack was generous in his responses I had an earlier post up with some interesting responses. Also check out an excerpt from the book I ran yesterday as well.
AR: One thing your book(s) show is that the best managers have adopted strategies that best fit their own personality. Therefore the range of strategies and tactics across managers is quite wide. It seems that investors could get caught up in trying to find managers only of like style and personality. Should fund investors focus more on quantitative measures like your gain-to-pain metric that put dissimilar styles on a equal footing?
JS: I believe your question mixes two separate roles: trader and investor. It is in respect to trading that I urge people to find a style that suits their personality. Some people are more comfortable with fundamentals than technical analysis, and others have the exact reverse preference. Some traders are comfortable with long-term positions, while others prefer short-term trading. And so on. Each trader must find a style that combines the characteristics that fits his or her personality. Investing, however, is a completely different story. Here, finding a manager that trades in a style that suits you is not all that relevant. Instead, you are looking for managers that are good in executing their own strategy style. Also, ideally, you would combine investments with multiple managers, using entirely different and uncorrelated approaches to get the benefits of diversification.
The Gain to Pain ratio, which as I defined my book is the sum of all monthly returns divided by the absolute value of the sum of only the monthly losses, is an excellent metric for comparing managers. There is one important proviso, though. This statement assumes that the track record provides an accurate reflection of risks inherent in the strategy. This assumption is often not valid. For many strategies, the inherent risks may occur only sporadically and may not be evident in the track record. For example, a manager who sells out-of-the-money options could have an extremely smooth equity stream and look like he has very low risk, as long as there hasn’t been any abrupt, large price move during the lifespan of the track record. Such a manager could also have an excellent Gain to Pain ratio. However, in this example, the true risks of the strategy are not reflected in the track record. So it is very important to make this distinction—that is, whether risks inherent in the strategy are adequately reflected by past returns—before using the Gain to Pain ratio or, for that matter, any performance metric to make manager comparisons.
AR: On my blog and in my book I have noted the fact that most investors don’t have the interest, inclination or skills to be active investors, nor do they have access to managers like those chronicled in your book. So for those investors who have 401(k) funds, IRAs and who are investing retirement are there lessons they can distill from these managers? For example is following a Greenblatt-inspired index a better option than plain vanilla indexing?
JS: Let me preface this reply by making clear that I’m not offering specific investment advice here. Also, Greenblatt’s equity indexes are relatively new and have short track records. With those provisos in place, I would say without reservation that the premise underlying Greenblatt’s indexes makes much more intuitive sense to me than the construction of conventional indexes. Most indexes are capitalization weighted. What that means in practical terms is that the higher a stock goes—and often the more overvalued a stock becomes—the greater its share of the index. Similarly, in a conventional index, the more undervalued a stock becomes, the smaller its share of the index. This behavior is exactly the opposite of what you would want to happen for a long-term investment, which is what equity indexes are often used for. Greenblatt’s indexes not only eliminate capitalization weighting distortions, but effectively do the reverse by weighting equities based on valuation criteria—that is, the greater the value of an equity based on the evaluation criteria, the larger the allocation. That makes a lot more sense to me. I would also add that Greenblatt’s approach should not be confused with conventional value indexes, which select a subset of stocks as falling into the value category, but then weight those stocks by capitalization. In contrast, Greenblatt’s indexes place more weight on the cheaper companies (rather than the large-cap companies), which is an entirely different thing.
AR: Many of the interviewees in your book mention the influence of prior books, as have many interviewers in discussing this book. You note in your book the fact that your son has become a trader as well. What is it about this approach, interviews with outstanding managers, that strikes such a chord with readers? In that same light you talk about having some qualms that your books may have gotten people to begin trading who may very well should have kept their day job. Do you ever feel the need to put big disclaimers about who should (and should not) read your books?
JS: Many readers have told me that my Market Wizard books changed their lives–for the better. For these readers, the books provided inspiration and lessons that led to satisfying and profitable trading careers. In fact, many of the managers I have interviewed told me that my books were an important influence in their becoming traders. However, I do sometimes have concern that my books may influence readers to give up jobs that have a greater benefit to society (e.g., doctors becoming traders because of my books; I know this has happened) or influence some readers who are not well-suited to trading to pursue trading careers. I believe that prospective traders need to be honest in questioning themselves as to whether they really want to be traders. Not everyone can be a successful trader, and not everyone would be happy with a career as a trader. Too many people pursue trading because they think it is an easy way to make a lot of money rather than because it is a passion or something they were meant to do.
Thanks to Jack for participating and generously answering our questions. You can find Jack’s latest book, Hedge Fund Wizards at Amazon. For those interested in other interviews Jack has done check out his interviews with Michael Martin of MartinKronicle and Andrew Horowitz of The Disciplined Investor podcast.
*We received a copy of Hedge Fund Wizards from the publisher.