Winning the Loser’s Game By Charles D Ellis Book Summary
Winning the Loser’s Game, Timeless Strategies for Successful Investing, Eighth Edition by Charles D. Ellis
Recommendation
In this updated investing classic, market expert Charles D. Ellis offers a solid and unbiased analysis of how markets work today, and he explains why even the best professionals can no longer expect to sustain a winning streak. The savviest strategy for individual investors, he argues, is to invest in low-cost index funds where the objective is to replicate – not outperform – the broad market. While getAbstract never offers investment advice, it believes that anyone saving and investing to achieve a comfortable retirement and other goals will want this important reference book in their libraries.
Take-Aways
- It’s no longer possible to beat the market.
- Active investment is not a zero-sum game but a negative-sum game.
- Professional stock pickers try to find anomalies in share prices.
- Over the long haul, index investing produces better results than most actively managed funds and almost all individual investors.
- An investor loses simply by being out of the market.
- Diversification minimizes the risk of individual stocks and stock groups, but overall market risk comes with investing.
- Individual investors’ objectives, motivations and behavior differ from those of institutional investors.
Winning the Loser’s Game Book Summary
It’s no longer possible to beat the market.
The traditional notion of investment management holds that beating the market is possible and that superior management will do the job. In any given year, a couple of funds may do better than the averages, but sustained outperformance is rare indeed. In the dim past, experts with information and skills could beat the market. Nowadays, the market effectively consists of institutions with state-of-the-art technology. Nearly all trades in listed stocks are executed by institutional investors. The professionals trading for these institutions all have the same good technical capability and data. Their collective decisions establish the prices of stocks, so these professionals can’t beat themselves. In fact, when fees and expenses enter the calculation, most fund managers will underperform the broad market indexes. Individual investors, moreover, will underperform the professionals by a large margin.
“The reason investing has become a loser’s game even for dedicated professionals 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.”
Take a lesson from tennis. Dr. Simon Ramo, an engineer, studied the game closely and found significant differences between a professional player’s game and that of most amateurs. Professionals excel at hitting the ball where they want it to go, forcing their opponent into a loss. Amateurs, however, make a lot of mistakes. In professional tennis, the winner determines the final score. In the amateur game, the loser’s errors determine the result. Institutional investing used to be a winner’s game. However, as professional investors with excellent information access and powerful computers have come to dominate the market, they now establish the consensus value.
Active investment is not a zero-sum game but a negative-sum game.
For the majority of investors, the hardest part of investing is sticking with the plan, no matter what happens in the markets and no matter what emotions arise. Professional investment advisers help clients set realistic and appropriate long-term objectives and policies. However, fees and expenses take a big bite out of whatever returns an active manager does generate, and those returns are not likely to match those of the market. A reasonable estimate of pretax operating costs for the typical mutual fund is 3.25%. So just to break even, an active manager has to recover that cost. With an estimated future rate of return for the market of about 7%, this means that the manager must return, before expenses, 10.25% just to match the market average. To outperform professional peers, it would be necessary to regularly find them making mistakes and to exploit those mistakes quicker than anyone else.
“For 9 out of 10 deciles of past performance, future performance is virtually random.”
The stock market is not what it used to be. Trading volume on the New York Stock Exchange has risen more than 2,000 times, with proportionately similar volume increases on other major exchanges. Today, derivatives trading is even greater than trading in the cash market.
The US Regulation Fair Disclosure, known as RegFD, requires public companies to make all information available to everyone simultaneously. Before RegFD, privileged access to information could give an active professional trader a big advantage. Now, that valuable edge is a mere commodity. Algorithmic and other forms of quantitative trading substantially influence the market. On top of that, the number of professional capital markets investors has multiplied from 5,000 to more than a million. None of them has an information advantage over the others; they all have 24-hour access through more than 345,000 Bloomberg terminals. Consequently, markets have become more efficient, and it is harder than ever for any investor to beat the market. In their advertisements, investment firms cherry-pick funds to highlight, selecting those that have turned in good returns over selective time periods. Some managers maintain hundreds of funds, so there will always be a few that look like winners.
Professional stock pickers try to find anomalies in share prices.
Price setting is a collective effort by all institutional investors with access to the same data. The only way to beat the market is to beat those professionals, and opportunities to get an advantage are rare. So, if it efficiently reflects real value, why does the market rise and fall? Understanding how other market participants think and anticipating their moves is part of an investor’s calculation of future value. Even small nuggets of information or misinformation can have huge market consequences. Long-term investors should steel themselves against the distractions from short-term market movements. Studying the history of markets to understand how they have acted in the past can provide insight into how they are likely to act in the future. Such insight can help you keep your head while others are losing theirs. Anomalies do happen and are part of the market’s normal behavior.
“All forms of active investing have one fundamental characteristic in common: They depend on the errors of others.”
By using an index fund, which replicates market performance, you can effectively assemble a team of the most knowledgeable and experienced professionals in the world and supplement their advice with research from the best analysts. Numerous investing experts, including Warren Buffett and Nobel laureates, recommend indexing for most individual investors. In addition to providing returns that most actively managed funds cannot equal, much less beat, index funds also bring less tax liability, and they charge lower fees. Index investors will see ups and downs, but they will not have to worry that their investment manager has made the wrong guess about timing the market.
Over the long haul, index investing produces better results than most actively managed funds and almost all individual investors.
The index investor can concentrate on developing a portfolio that reduces the probability of error and enhances the likelihood of achieving objectives. Investing has two risks: investment risk and investor risk. Numerous studies show that active investment costs more than it returns; no studies support the contrary. The formula for successful investing is to define the objectives, select an appropriate mix of assets and stay the course. Indexing makes this easier. The index investor need not worry about a company’s management problems or its acquisition by another firm, or about internal issues with a financial adviser. The strongest argument for indexing occurs in the major markets, such as those in the United States, the United Kingdom and Japan.
Diversification optimizes the risk-return trade-off. Therefore, the most prudent investors will choose a fund representing a total market. Individuals should avoid narrowly focused, specialized exchange-traded funds; professionals use these to tweak their risk management.
“Winning investors are not in competition with one another; they are in competition only with themselves.”
Only by holding on through thick and thin can the long-term investor realize the expected returns. This is why it is important to understand how capital markets work. Every investor has a “zone of competence” and a “zone of comfort,” and it is important to stay within both. Straying from the competence zone leads to expensive blunders; getting out of the comfort zone carries the risk of irrational, emotional decisions. Investment portfolios should be tailor-made for an investor’s age, assets, risk tolerance and other characteristics that differ from person to person. Only you as an investor can set your investment policy, whether or not you collaborate with a professional adviser. Neglecting such an assessment introduces the risk of managing long-term investments according to short-term developments.
An investor loses simply by being out of the market.
The greatest returns of the S&P 500 happened on less than 1% of the trading days in a 20-year period. Missing just the five best days in 72 years of trading would cut a portfolio’s returns in half. Although market timing does not work, time itself is a crucial consideration in investing. Time does not change the average expected return, but it can greatly affect fluctuations around the average. The longer the portfolio time horizon, the more probable it is that portfolio returns will approximate the average expected returns. The relative returns of stocks, bonds and cash differ significantly, according to the holding periods. The proportion of fixed income investments and equities is the most important consideration in your investment policy. Conventional recommendations of 60% equities and 40% debt may be reasonable for a five-year horizon but wrong for an investor with a 30- or 50-year horizon. Long-term investors know about regression to the mean and understand that both economic and market forces move eventually toward the average.
“If the market has been going up, investors, who curiously usually evaluate future prospects by looking into the rearview mirror, will assume some further upward momentum.”
Investment history shows that, on average, common stocks return more than bonds, which in turn return more than money market investments. Stock returns fluctuate more than bond returns, which similarly fluctuate more than money market returns, and the volatility of returns increases the shorter the investment time span.
Diversification minimizes the risk of individual stocks and stock groups, but overall market risk comes with investing.
Stocks of different companies may share similarities if they’re in the same industry or show the same pattern of growth, and they may exhibit similar risks. An investor who takes individual stock or stock group risk can only win if the expert consensus of the overall market is wrong about that investment’s value. Index funds provide the diversification that eliminates individual stock and stock group risk. The most important investment decisions are those that define the appropriate objectives and asset mix.
“Managing market risk to suit the investor is the primary tool of investment management.”
In the short run, a manager whose performance is significantly above or below the expected return is probably off mission. It is all too easy for the individual investor to mistake luck for skill. Some 90% of actively managed mutual funds that invest domestically have underperformed the benchmark index they were trying to beat. Only 11% managed to match the performance of their index over a 15-year time frame. The reality is even worse than these statistics indicate. Investment firms have several ways to give investors a falsely positive impression of their fund performance. They don’t, for example, report on funds they have closed, and more than 40% of domestic mutual funds close within 15 years.
Individual investors’ objectives, motivations and behavior differ from those of institutional investors.
Individual investors see money in a way that’s different from how institutional investors regard funds. For some people, the money they’ve amassed during their lives comes to symbolize what they’ve accomplished. Thus, money can take on emotional connotations, and those who are approaching or are in retirement might make financial decisions based on sentiment rather than economic rationality.
“Mortality is a dominant reality for all individual investors.”
For most people, investment begins with savings. Think of saving as something positive rather than as a form of self-denial. Specify savings goals, then plan a schedule to achieve those targets. Keep your focus on the idea that the purpose of saving is to achieve a better lifestyle. When you’re ready to invest what you’ve saved, minimize fees, taxes and expenses by indexing, and don’t forget to take inflationary expectations and their potential impacts on your portfolio into account.
“If you have successfully saved and invested enough to have ample funds for all your chosen responsibilities and obligations, you have truly won the money game. Bravo! This is an appropriately thrilling achievement.”
For an individual, the best long-term investment is in equities. Conventional wisdom says that older investors should have most of their money in bonds. However, that may not be so wise, especially in a low interest rate environment. The elderly may not have long personal time horizons, but their investment portfolios might. Children, grandchildren and other beneficiaries gain from the foresight of the investor who thinks about the future and invests in equity index funds.
About the Author
Charles D. Ellis founded Greenwich Associates, an international consulting firm, and he is a consultant to large institutional investors, government organizations and high-net-worth families.
