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Market Sense and Nonsense: How the Markets Really Work (and How They Don't) by Joel Greenblatt, Jack D. Schwager

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Chapter 6

Track Record Pitfalls

Track records can mislead as well as enlighten. Some of the major pitfalls in drawing inferences from track records include the following:

1. Hidden risk.
2. Irrelevant data.
3. Good performance due to high risk rather than manager skill.
4. Apples-and-oranges comparison errors.
5. Longer records that are less meaningful.

Hidden Risk

A primary way in which track records mislead is by what is not there. The track record may not reflect the types of risk inherent in a fund if it is a strategy that is exposed to sporadic risk events and no such event is contained in the track record. In this case, the track record would be unrepresentative and possibly highly misleading. This essential concept was fully discussed in Chapter 4.

The Data Relevance Pitfall

Figure 6.1 shows that the bond market has been in a general uptrend for the past 30 years. Consider the implications of this track record for the bond allocation in portfolios employing widely used portfolio optimization approaches. Portfolio optimization will provide the optimal asset mix to get the highest return for any targeted level of volatility (used as a proxy for risk). The results of portfolio optimization are based on the past return and volatility levels of the individual assets and the correlation levels between these assets. Generally speaking, the larger and more sustained an uptrend in bonds, the larger its allocation in an optimized portfolio.

Figure 6.1 Treasury Bond Continuous Futures ...

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