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WINNING THE LOSER'S GAME
Timeless Strategies for Successful Investing
By Charles D. Ellis
McGraw-Hill, Inc.
Copyright © 2010 Charles D. Ellis
All right reserved.
ISBN: 978-0-07-154550-1
Chapter One
THE LOSER'S GAME
Disagreeable data are streaming steadily out of the computers of performance measurement firms. Over and over again these facts and figures inform us that mutual funds are failing to "perform" or beat the market. Occasional periods of above-average results raise expectations that are soon dashed as false hopes. Contrary to their often-articulated goal of outperforming the market averages, the nation's investment managers are not beating the market; the market is beating them.
Faced with information that contradicts what they believe, people tend to respond in one of two ways. Some ignore the new knowledge and hold to their former beliefs. Others accept the validity of the new information, factor it into their perception of reality, and put it to use. Most investment managers and most individual investors, being in a sustained state of denial, are holding onto a set of romantic beliefs developed in a long-gone era of different markets. Their romantic views of "investment opportunity" are repeatedly proving to be costly.
Investment management, as traditionally practiced, is based on a single basic belief: Investors can beat the market. Times have changed the markets, and that premise now appears to be false even for most professional investment managers. (See Figures 1.1 and 1.2.)
As shown above, in most years a majority of equity funds are beaten by the market. It gets worse during large periods of time, such as over a decade, where 68 percent of equity funds get beaten by the market.
If the premise that it is feasible to outperform the market were true, then deciding how to go about achieving success would be a matter of straightforward logic.
First, since the overall market can be represented by a public listing such as the Wilshire 5000 Total Market Index, a successful manager would only need to rearrange his or her portfolios more productively than the "mindless" index. The manager could be different in stock selection, strategic emphasis on particular groups of stocks, market timing, or various combinations of these strategies.
Second, since an active manager would want to make as many "right" decisions as possible, he or she would assemble a group of bright, well-educated, highly motivated, hardworking professionals whose collective purpose would be to identify under-priced securities to buy and overpriced securities to sell—and beat the market by shrewdly betting against the crowd.
Unhappily, the basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot, as a group, outperform themselves. In fact, given the cost of active management—fees, commissions, market impact of big transactions, and so forth—85 percent of investment managers have and will continue over the long term to underperform the overall market.
Because investing institutions are so numerous and capable and determined to do well for their clients, professional investment management is not a "winner's game." That's why a large majority of mutual funds, pension funds, and endowments are not successful: Professional investing has become a loser's game.
Individual investors investing on their own do even worse—on average, much worse. (Day trading is the worst of all: A sucker's game. Don't do it—ever.)
Before analyzing what happened to convert institutional investing from a winner's game to a loser's game, consider the profound difference between these two kinds of games. In a winner's game, the outcome is determined by the correct actions of the winner. In a loser's game, the outcome is determined by mistakes made by the loser.
Dr. Simon Ramo, a scientist and one of the founders of TRW Inc., identified the crucial difference between a winner's game and a loser's game in an excellent book on game strategy, Extraordinary Tennis for the Ordinary Tennis Player. Over many years Dr. Ramo observed that tennis is not one game but two: one played by professionals and a very few gifted amateurs, the other played by all the rest of us.
Although players in both games use the same equipment, dress, rules, and scoring, and both conform to the same etiquette and customs, they play two very different games. After extensive statistical analysis, Ramo summed it up this way: Professionals win points; amateurs lose points.
In expert tennis the ultimate outcome is determined by the actions of the winner. Professional tennis players stroke the ball hard with laserlike precision through long and often exciting rallies until one player is able to drive the ball just out of reach or force the other player to make an error. These splendid players seldom make mistakes.
Amateur tennis, Ramo found, is almost entirely different. The outcome is determined by the loser. Here's how. Brilliant shots, long and exciting rallies, and seemingly miraculous recoveries are few and far between. The ball is all too often hit into the net or out of bounds, and double faults at service are not uncommon. Instead of trying to add power to our serve or hit closer to the line to win, we should concentrate on consistently getting the ball back. Amateurs seldom beat their opponents but instead beat themselves. The victor in this game of tennis gets a higher score because the opponent is losing even more points.
As a scientist and statistician, Ramo gathered data to test his hypothesis in a clever way. Instead of keeping conventional game scores—15 love, 15 all, 30—15, and so forth—Ramo simply counted points won versus points lost. He found that in expert tennis about 80 percent of the points are won, whereas in amateur tennis about 80 percent of the points are lost.
The two games are fundamental opposites. Professional tennis is a winner's game: The outcome is determined by the actions of the winner. Amateur tennis is a loser's game: The outcome is determined by the actions of the loser, who defeats himself or herself.
The distinguished military historian Admiral Samuel Eliot Morison makes a similar central point in his thoughtful treatise Strategy and Compromise: "In warfare, mistakes are inevitable. Military decisions are based on estimates of the enemy's strengths and intentions that are usually faulty, and on intelligence that is never complete and often misleading. Other things being equal," concludes Morison, "the side that makes the fewest strategic errors wins the war."
War is the ultimate loser's game. Amateur golf is another. Tommy Armour, in his book How to Play Your Best Golf All the Time, says: "The best way to win is by making fewer bad shots." This is an observation with which all weekend golfers would concur.
There are many other loser's games. Like institutional investing, some were once winner's games but have changed into loser's games with the passage of time. For example, 90 years ago only very brave, athletic, strong-willed young people with good eyesight had the nerve to try flying an airplane. In those glorious days, flying was a winner's game. But times have changed, and so has flying. If the pilot of your 747 came aboard today wearing a 50-mission hat and a long white silk scarf around his or her neck, you'd get off. Such people no longer belong in airplanes because flying today is a loser's game with one simple rule: Don't make any mistakes.
Often, winner's games self-destruct because they attract too many players, all of whom want to win. (That's why gold rushes finish ugly.) The "money game" we call investment management evolved in recent decades from a winner's game to a loser's game because a basic change has occurred in the investment environment: The market came to be dominated in the 1970s and 1980s by the very institutions that were striving to win by outperforming the market. No longer is the active investment manager competing with cautious custodians or amateurs who are out of touch with the market. Now he or she competes with other hardworking investment experts in a loser's game where the secret to winning is to lose less than the others lose.
Today's money game includes a formidable group of competitors. Several thousand institutional investors—hedge funds, mutual funds, pension funds, and others—operate in the market all day, every day, in the most intensely competitive way. Among the 50 largest and most active institutions, even the smallest spends $100 million in a typical year buying services from the leading broker-dealers in New York, London, Frankfurt, Tokyo, Hong Kong, and Singapore. Understandably, these formidable competitors always get the "first call" with important new information. Thus, about half the time that we individual investors buy and about half the time we sell, the "other fellow" is one of those giant professionals, with all their experience and all their information and all their analytical resources.
The key question under the new rules of the game is this: How much better must the active mutual fund investment manager be to at least recover the costs of active management? The answer is daunting. If we assume 100 percent portfolio turnover (implying that the fund manager holds a typical stock for 12 months, which is slightly longer than average for the mutual fund industry) and we assume total trading costs (commissions plus the impact of big trades on market prices) of 1 percent to buy and 1 percent to sell (again, average rates), plus 1.25 percent in fees and expenses for active management, the typical fund's operating costs are 3.25 percent per year. (A few well-managed mutual funds, such as the American Funds, are longer-term investors and therefore have much lower turnover, lower operating costs, and better results.)
Recovering these costs is surprisingly difficult in a market dominated by professional investors who are intensely competitive, extraordinarily well informed, and continuously active—and who make few large operational ITLµITL-mistakes. (Even the pros make macro-mistakes, particularly being fully invested together at market peaks, or choosing dot com stocks together.) When they do make micro-mistakes, they correct their errors quickly or see them exploited and quickly "corrected" by their professional competitors. (Individual investors make more macro-mistakes—going with the crowd when "everyone knows" it's a new dot-com era or fears a global credit collapse.) An active manager must overcome the drag of 3.25 percent on annual operating costs. If the fund manager is only to match the market's historical 10 percent return after all costs, he or she must return 13.25 percent before all those costs. In other words, for you merely to do as well as the market, your fund manager must be able to outperform the market return by—nearly one-third—32.5 percent!
That's why the stark reality is that most money managers and their clients have not been winning the money game. They have been losing. The historical record shows that on a cumulative basis, over three-quarters of professionally managed mutual funds underperform the S&P 500 stock market index. And for active individual investors, the record is even worse. Thus the burden of proof is on the person who says, "I am a winner; I will win the money game."
For any one manager to outperform the other professionals, he or she must be so skillful and so quick that he or she can regularly catch the other professionals making mistakes—and systematically exploit those mistakes faster than the other professionals. (The alternative approach—"slow investing"—is to base decisions on research with a long-term focus that will catch other investors obsessing about the short term and cavitating—producing bubbles.)
Working efficiently, as Peter Drucker so wisely explained, means knowing how to do things the right way, but working effectively means doing the right things. Since most investment managers will not beat the market, investors should at least consider investing in "index funds" that replicate the market and so never get beaten by the market. Indexing may not be fun or exciting, but it works. The data from the performance measurement firms show that index funds have outperformed most investment managers over long periods of time.
The reason investing has become a loser's game for the professionals who manage most of the leading mutual funds and investment management organizations is that their efforts to beat the market are no longer the most important part of the solution; they are now the most important part of the problem. As we learn in game theory, each player's strategy should incorporate understanding and anticipation of the strategies and behavior of other players. In the complex problem each investment manager is trying to solve, his or her efforts to find a solution—and the efforts of the many determined competitors—have become the dominant adverse variables facing active managers.
For most investors, the hardest part is not figuring out the optimal investment policy; it is staying committed to sound investment policy through bull and bear markets and maintaining what Disraeli called "constancy to purpose." Sustaining a long-term focus at market highs or market lows is notoriously difficult. At either market extreme, emotions are strongest when current market action appears most demanding of change and the apparent "facts" seem most compelling.
Being rational in an emotional environment is never easy. Holding onto a sound policy through thick and thin is both extraordinarily difficult and extraordinarily important work. This is why investors can benefit from developing and sticking with sound investment policies and practices. The cost of infidelity to your own commitments can be very high.
An investment counselor's proper professional priority is to help each client identify, understand, and commit consistently and continually to long-term investment objectives that are both realistic in the capital markets and appropriate to that particular investor's true objectives. Investment counseling helps investors choose the right objectives.
It's not active managers' fault that their results are so disappointing. The competitive environment within which they work has changed dramatically in 50 years from quite favorable to very adverse—and it is getting worse and worse.
Before examining the changes in the investment climate, let's remind ourselves that active investing is, at the margin, always a negative-sum game. Trading investments among investors would by itself be a zero-sum game, except that costs such as commissions, expenses, and market impact must be deducted. These costs total in the hundreds of billions every year. Net result: Active investing is a seriously negative-sum game.
To achieve better than average results through active management, you depend directly on exploiting the mistakes and blunders of others. Others must be acting as though they are willing to lose so that you can win after covering all your costs of operation. Even in the 1960s, when institutions did only 10 percent of the public trading and individual investors did 90 percent, large numbers of amateurs were realistically bound to lose to the professionals. We can understand why this was—and is—the reality of the situation by reviewing some of the characteristics of individual investors.
Individual investors usually buy for reasons outside the stock market: They buy because they inherit money, get a bonus, sell a house, or, for any other happy reason, have money to invest as a result of something that has no direct connection to the stock market. Similarly, they sell stocks because a child is going off to college or they have decided to buy a home—almost always for reasons outside the stock market. Candidly, when individuals act because of reasons they think are inside the market, they are usually making a mistake; they are either optimistic and late because the market has been rising or pessimistic and late during a falling market.
In addition, compared to the full-time well-organized institutions, individual investors typically do not do extensive, rigorous comparison-shopping across the many alternatives within the stock market. Most individual investors are not experts on even a few companies. Many rely for information from newspapers, cable television, the Internet, friends, or retail stockbrokers—many of whom are seldom experts. Individuals may think they know something important when they invest, but almost always what they think they know is either not true or not relevant or not important new information. The amateur's "scoop" is already known and factored into the market price by the professionals who are active in the market all the time. Thus, the activity of most individual investors is what market researchers correctly call "informationless" trading or "noise." (These terms are not rude; they are simply descriptive. Anyone who feels offended by them is just being too sensitive.)
(Continues...)
Excerpted from WINNING THE LOSER'S GAME by Charles D. Ellis Copyright © 2010 by Charles D. Ellis. Excerpted by permission of McGraw-Hill, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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