This is part of a series of future posts summarizing and analyzing key points made by traders interviewed in Market Wizards by Jack D. Schwager. Market Wizards is a collection of interviews with some of the world’s most successful traders and investors including Paul Tudor Jones, Michael Steinhardt, and Bruce Kovner. The book is widely recommended by traders and investment professionals and is included on the Sharpe Investing Recommended Reading List.
This first post focuses on a section about Larry Hite titled Respecting Risk. Managing risk is the key focus of Hite’s investment strategy. …

This interesting PBS video explains the rise and the risks of hedge funds. The video does a good job of explaining the potential negative impact from the dramatic amount of leverage used by some hedge funds. Also, the video features hedge fund manager and author Nicholas Taleb, who discusses the posibility of black swan events.

Background
Long Term Capital Management(LTCM) was a hedge fund established in 1994 by John Meriwether, a very successful bond trader at Salomon Brothers. At Salomon, Meriwether was one of the first on wall street to hire top academics and professors. Meriwether established a team of academics who applied models based on financial theories to trading. At Salomon, Meriwether’s group of geniuses generated amazing returns and demonstrated an unparalleled ability to precisely calculate risk and other market factors.
In 1994, Meriwether left Salomon and established LTCM. The partners included two Nobel Price-winning economists, …

Volatility Definition
In finance, volatility is a statistical measurement of up and down asset price fluctuations over time. If an asset has rapid dramatic price swings, volatility will be high. If prices are consistent and rarely change, volatility is low. Volatility can be measured as the annualized standard deviation.
Volatility as Measure of Risk
Volatility is often used to measure risk. Many common measurements of risk, such as beta, utilize volatility in calculations. It makes sense that an asset that has had huge price swings is more risky than an asset that is …

Normal distributions (a bell curve) of asset returns is a key assumption made by many financial models, including the capital asset pricing model(CAPM) and the Black-Scholes option pricing model(BSM). However, actual asset returns may not be so normal.
Normal Distributions Overestimate the Improbability of Unlikely Market Events
Using a normal distribution, events that diverge from the mean by five or more standard deviations, known as a five-sigma event, are very rare and ten-sigma events are nearly impossible. For example, the 1987 market plunge represents a change equalling 22 standard deviations. The odds …

The Sortino ratio is a financial ratio, similar to the Sharpe ratio, that measures the risk-adjusted return of investments or portfolios. Unlike the Sharpe ratio, the Sortino uses downside-volatility(sometimes referred to as semi-volatility) as the denominator instead of standard deviation. The use of downside-volatility allows the Sortino ratio to measure the return of “negative” volatility.
Downside deviation differentiates “positive” volatility from “negative” volatility, unlike standard deviation. Standard deviation is the square root of volatility. However, using standard deviation as a measure of risk may not be completely accurate. For example, assume …