Determining how great traders acquire and use their special skills has been an elusive quest. We have no shortage of cookbooks on how to trade, but only a limited number of books describe the decision processes of those who speculate as a profession. Trader confessionals exist often as testimonies to egos, but few focus on the details of decision making.1
Material that does successfully capture the essence of how speculators think is the Market Wizards series by Jack D. Schwager. These books are neither cookbooks nor testimonials but question-and-answer conversations with traders who talk about their thought processes, how they entered the business, their trading styles, and market battles they have undertaken. These interviews provide a sense of realism about how traders think. The interviewees are not always extraordinary individuals; often, they are simply hard-working professionals who manage the anxieties and uncertainties of trading by developing styles that work within the comfort of their skills and personalities.
Schwager has created a cottage industry out of these trader conversations, and now, over two decades since his first book, Market Wizards: Interviews with Top Traders,2 he adds a fourth book that focuses on hedge fund managers. Readers will not feel shortchanged; the book has 15 new trader interviews, divided by style into macro, multistrategy, and equity sections. Some of the traders, such as Joel Greenblatt, Ray Dalio, and Ed Thorp, are well known, whereas others may never become household names. Each has a story that provides insight into how speculators go about their business.
Even in the interviews of well-known traders, Schwager’s probing questions extract many new insights. For example, the Ed Thorp interview, which is the longest, is almost worthy of a book in itself. It recounts the complex journey of one of finance’s most interesting characters from skeptical academic to blackjack card counter and finally to successful speculator.3
The focus of the conversations varies with each interviewee. Some are good at providing memorable quotes, whereas others furnish voluminous facts about their craft, but each describes finding a way to play the game of trying to beat the market. Although the interviews are wide ranging, each has a major theme or lesson. For example, macro trader Ray Dalio’s interview is titled “The Man Who Loves Mistakes” because he believes one learns the most from one’s errors. Multistrategy player Jami Mai’s interview is called “Seeks Asymmetry” because he searches for large market distortions. Steve Clark, an equity trader, focuses on a simple rule: “Do more of what works and less of what does not.”
Regardless of one’s investment style or market focus, this book provides much to learn. It details many variations regarding which markets to trade in, what time frame to incorporate, and how to use information. The wizards trade in all markets, including futures, options, equities, and bonds. They may be broad macro thinkers, risk arbitrageurs, fundamentalists, quants, or technicians. A recurring theme is that successful traders follow their own muse. A strategy that works for one could be a disaster for another.
The wizards improvise and adapt to find a comfort zone even though their basic trading principles are similar. They are like jazz musicians who modify a basic song to fit their own styles. Adaptation is a continuing process for them; they do not stick with one way of thinking for success. As Colm O’Shea says, “If they do use rules and you meet them 10 years later, they will have broken those rules. Why? Because the world changed.”
Schwager’s interviews reveal that successful trading is consistent with the findings of formal research on decision making and behavioral finance. Commonalities can be found among the wizards’ frameworks for forecasting and determining odds, managing trade and portfolio risks, and focusing behavior through psychological discipline. Every trader interviewed has a method for measuring the return to risk of each trade. They all generate expected payoffs and develop scenarios for both upside and downside outcomes. Forecasting skill is honed not only through forming expectations for fair value in prices but also through focusing on forecast precision. Still, as one trader points out, knowing when it is raining is as important as forecasting the weather.
The information the traders use in generating forecasts depends on the trading style. Quantitative traders estimate expected returns and well-defined odds of success on the basis of historical relationships. Short-term traders measure flow and sentiment to determine price behavior. Longer-term traders, who are often theme based, try to set bounds on risk in an uncertain world through economic logic and scenario analysis. Schwager manages to tease out how each trader goes about these complex tasks in many different markets.
The wizards spend much of their time comparing risk and uncertainty because, according to Mai, “Markets tend to overdiscount the uncertainty related to identifiable risks…[and]…underestimate risks that have not been expressly identified.” Quantitative work is undertaken in the context of fundamentals. As Dalio puts it, “Drivers are the cause, correlations are the consequence.” Unpredictable “stuff” happens, so all trades must have a margin of safety. This recurring theme is consistent with the view that the probability of any trade is not easily measurable, no matter how smart the trader is or how much information is gathered. When uncertainty or unknown risks increase, the expected payoff has to increase; more “gain to pain” is required. The wizards understand their personal capacity for taking risk and their skill in measuring it. They see the difference between risk intelligence (the ability to measure odds) and risk aversion (the unwillingness to take on certain risks). When a divergence occurs between their risk measure and their willingness to accept risk, good traders walk away.
The traders state that risk management is critical to success because failures are expected to occur often. Their rules for risk management remove the emotion of dealing with losses. A key insight is that the placement of stops should be based not on the pain of loss but, rather, at the level that indicates one’s forecast is wrong. Stops are not a pain threshold. Furthermore, a value-at-risk (VaR) framework is not a solution. Because “VaR doesn’t blow up portfolios, people do,” every one of the wizards has a risk management exit plan.
Controlled behavior is critical for success. All the wizards present an image of unflappability. The interviews convey an atmosphere of no drama, no broken phones, and no excessive jubilation. The air of professionalism is such that accepting failure is second nature and part of the game. Mistakes are recognized, and the unexpected is dealt with unemotionally and without remorse. The level of detachment among the wizards suggests that traders have a distinctive psychological makeup, a subject that would be interesting to explore further.4
Reading these trader interviews reveals parallels with the research of Nobel Prize winner Daniel Kahneman on fast thinking and slow thinking.5 Some decisions are rote simply because they are made frequently and the inputs are easy to measure. Unique problems, in contrast, require time and deliberate consideration through slow thinking.
Many successful traders engage in what has been termed “naturalistic” or “recognition-primed” decision making.6 It involves no formal computation process but, instead, an intuitive assessment of situations. This process is often hard for economists to accept but is likely a genuine component of successful trading. Without calling it a sixth sense, we should recognize that some traders have the ability to measure trade-offs quickly and see what others miss.
Schwager’s wizards firmly reject the belief in market efficiency. Markets are to be exploited. As one trader says, “I’d like to do a better job at monetizing other people’s irrational euphoria.” Holes in efficiency are identified by taking dissenting views of the same data others are analyzing. Jaffray Woodriff applies the concept of secondary variables propounded by baseball numbers guru Bill James. As the wizards see it, all market participants are constantly adapting to gain an edge, much as depicted in Michael Lewis’s Moneyball7 race. It is this Darwinian struggle that promotes efficiency. The wizards are the survivors.
A cognitive disconnect exists, however, between the wizards’ view that markets are inefficient and their belief that prices provide a great deal of information. Their take on price efficiency is that if the market moves against you, then you were wrong. Markets are efficient at telling you that your views are wrong. And, they believe, you will be wrong a lot.
The wizards’ success in becoming outliers in intensely competitive markets reflects a synthesis of skills with a special blend of individualism. Nevertheless, Malcolm Gladwell’s key observation in his book Outliers: The Story of Success8 is hiding beneath the surface of these discussions. These traders are extraordinary because of their desire to work at their craft for thousands of hours in spite of failures. They are not just about making money but also about being consistent winners to create sustainable careers. Schwager makes it clear that successful traders work extremely hard. There is no free lunch for these traders and no shortcut for the reader who hopes to find trading success without expending the necessary effort.
In hopes of helping readers become better traders, the book adds a section on 40 Market Wizards lessons, as if the interviews could be distilled into a rule book. Although these rules are useful, the real value of Hedge Fund Wizards lies in enabling readers to find directly in the interviews nuggets of useful information that resonate for them. Much of what is discussed in Hedge Fund Wizards can be gleaned from other sources or has been set down in so-called trading rule books. Still, the question-and-answer format, with traders telling in their own words how they developed their craft, is more engaging than any dry set of dictums.
Like the fourth installment of any good thing, this newest Market Wizards book suffers from diminishing marginal utility, and at more than 500 pages, it contains some repetition. The hedge fund wizards do not sound much different from the traders of one or two decades ago.
A minor flaw with Schwager’s approach is that it focuses on the individual and misses the institutionalization of hedge fund traders into money management firms. We learn little about how these individuals manage investment teams; in this book, the individual is still king. In addition, markets have gone through significant upheaval and structural change since Schwager’s first set of interviews in the 1980s, so we naturally expect this new book to offer a fresh take on how traders manage the complexity of products, markets, and information in the current environment. The lack of such insight is a minor disappointment in a work that shines in showing the individual’s triumph in devising ways to outwit the markets.
The Schwager series is so influential that the traders interviewed in this book refer to the original Market Wizards as central to their thought processes and their decisions to become speculators. Investors who have read all the Market Wizards books will conclude that good trading habits stand the test of time and allow an individual to adapt to any market, any environment, and any style. Ultimately, this book did not need “Hedge Fund” to modify “Market Wizards” in the title. The insights are not unique to hedge funds but are valuable because the traders are refreshing and thought-provoking investment professionals.
—M.S.R.