Winning the Loser's Game, 6th edition: Timeless Strategies for Successful Investingby Charles D. Ellis
The go-to guide for anyone seeking long-term gain in the stock market, Winning the Loser's Game was referred to by the great Peter Drucker as "by far the best book on investment policy and management."
Dr. Charles Ellis, dubbed "Wall Street's Wisest Man" by Money/i>/p>/i>
The classic guide to winning on Wall Street--completely updated and expanded!
The go-to guide for anyone seeking long-term gain in the stock market, Winning the Loser's Game was referred to by the great Peter Drucker as "by far the best book on investment policy and management."
Dr. Charles Ellis, dubbed "Wall Street's Wisest Man" by Money magazine, has been showing investors for three decades how stock markets really work and what individuals can do to be sure they are long-term winners. Now, in this new edition of his investing classic, Ellis helps you succeed in a market that's becoming more unpredictable by the day.
Applying wisdom gained from half a century of advising many of the leading investment managers and securities firms around the world, Ellis explains how individual investors can avoid common traps and get on the road to investment success. With fully updated facts, charts, and figures, this new edition of Winning the Loser's Game is packed with all new material, including:
- U.S. government bonds: Why they're no longer a safe bet for long-term investors
- Active management: Fees are higher than ever. Are they worth it?
- The investment management industry: They make huge profits--but how well do they serve you?
- Behavioral economics: Know yourself--and you'll be a better investor
With Winning the Loser's Game, you have everything you need to set realistic objectives and a powerful investing strategy that will take you well into retirement.
Experts praise Winning the Loser's Game:
"Charley Ellis has been one of the most influential investment writers for decades. This classic should be required reading for both individual and institutional investors." -- BURTON MALKIEL, Author, A Random Walk Down Wall Street
"The best book about investing? The answer is simple: Winning the Loser’s Game. Using compelling data and pithy stories, Charley Ellis has captured beautifully in this new and expanded edition of his classic work the most important lessons regarding investing. In today's unforgiving environment, it's a must-read!" -- F. WILLIAM McNABB III, Chairman and Chief Executive Officer, Vanguard
"No one understands what it takes to be a successful investor better than Charley Ellis and no one explains it more clearly or eloquently. This updated investment classic belongs on every investor’s bookshelf." -- CONSUELO MACK, Executive Producer and Managing Editor, Consuelo Mack WealthTrack
"A must-reread classic. . . ." -- MARTIN LEIBOWITZ, Managing Director, Morgan Stanley Research
"Winning the Loser's Game has long been required reading for professional investors. . . . This elegant volume explores approaches for individuals, such as relying on intellect rather than emotion and building a personal portfolio by taking advantage of what other investors already know." -- ABBY JOSEPH COHEN, Goldman Sachs & Co
"This is less a book about competition than about sound money management. Sounder than Charley Ellis they do not come." -- ANDREW TOBIAS, Author, The Only Investment Guide You'll Ever Need
"Winning the Loser's Game is one of those timeless investing classics that is even more valuable today than when it was first published. Reading it again, in the context of two 50 percent-plus stock market crashes since 1999, will demonstrates the wisdom of Ellis' advice.” -- CBS MONEYWATCH.COM
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WINNING THE LOSER'S GAME
Timeless Strategies for Successful Investing
By Charles D. Ellis
McGraw-Hill EducationCopyright © 2013 Charles D. Ellis
All rights reserved.
THE LOSER'S GAME
Disagreeable data are streaming St Eadily out of the computers of performance measurement firms. Over and over again these facts and figures inform us that most mutual funds are failing to "perform" or beat the market. The same grim reality confronts institutional transfers such as pension and endowment funds. 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, 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 core belief: Investors can beat the market and superior managers will beat the market. Times have changed the markets so much that premise has proven unrealistic: in round numbers, over one year 60 percent of funds underperform (see Figures 1.1 and 1.2); over 10 years 70 percent underperform, and over 20 years about 80 percent underperform their chosen benchmarks.
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 differ in adequate 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. Today, the institutions are the market. Institutions do over 95 percent of all exchange trades and an even higher percentage of off-board and derivatives trades. It is precisely because investing institutions are so numerous and capable and determined to do well for their clients that investment has become a loser's game. Talented and hardworking as they are, professional investors cannot, as a group, outperform themselves. In fact, given the cost of active management—fees, commissions, market impact of big transactions, and so forth—investment managers have and will continue to underperform the overall market.
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 into a loser's game, consider the profound difference between 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. Amateurs seldom beat their opponents. Instead they beat themselves. The actual 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 so the other player has "every opportunity" to make a mistake. The victor in this game of tennis gets a higher score because the opponent is losing even more points.
As a scientist and statistician, to test his hypothesis Ramo gathered data in a clever way. Instead of keeping conventional game scores—15 love, 15 all, 30–15, etc.—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 made 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 still call investment management has 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 by the very institutions that were striving to win by outperforming the market. No longer is the active investment manager competing with overly cautious custodians or overly confident amateurs who are out of touch with the fast-moving 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. The central problem is clear! As a group, professional investment managers are so good that they make it nearly impossible for any one professional to outperform the market they together now dominate.
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, almost every time individual investors buy or sell, the "other fellow" is one of those giant professionals, with all their experience, all their information, and all their computers and analytical resources.
And what tough professionals they are! Top of their class in college and at graduate school, they are "the best and the brightest"—disciplined and rational, supplied with extraordinary information by thousands of analysts who are highly motivated, hardworking, and very competitive—and all are playing to win. Sure, professionals make errors and mistakes, but the other pros are always looking for any error and will pounce on it. Important new investment opportunities simply don't come along all that often, and the few that do certainly don't stay undiscovered for long. (Regression to the mean, the tendency for behavior to move toward "normal" or average, is a persistently powerful phenomenon in physics and sociology and investing.) Yes, several funds beat the market in any particular year and some in any decade, but scrutiny of the long-term records reveals that very few funds beat the market averages over the long haul—and nobody has yet figured out how to tell in advance which funds will do it.
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 mutual fund fees and expenses, the typical fund's operating costs are 3.25 percent per year.
An active manager must overcome the drag of about 3.25 percent in annual operating costs. If the fund manager is only to match the market's historical 9 percent return, he or she must return 12.25 percent before all those costs. In other words, to do merely as well as the market, an active fund manager must be able to outperform the market return by over one-third or 34.1 percent!
Achieving such superiority is exceedingly difficult in a market dominated by professional investors who are intensely competitive, extraordinarily well informed, and continuously looking for any opportunity.
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. So 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. (Even the pros make macro-mistakes, particularly being fully invested together at market peaks, or choosing dot com stocks together. When they make ITLµITL-mistakes, they correct their errors quickly or see them exploited and quickly corrected by their professional competitors.)
The reason investing has become a loser's game for 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. 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.
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.
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 kind of 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 keeps getting worse and worse because so many brilliant people with extraordinary equipment and access to information keep joining in the competition.
Before examining the many powerful 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 the large costs of management fees and expenses plus commissions and market impact must be deducted. These costs total in the 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.
Even more discouraging to investors searching for superior active managers is that those managers who have had superior results in the past are not particularly likely to have superior results in the future. In investment performance, the past is not prologue except for the grim finding that those who have repetitively done badly are unlikely to break out of their slough of despair and do well.
Excerpted from WINNING THE LOSER'S GAME by Charles D. Ellis. Copyright © 2013 Charles D. Ellis. Excerpted by permission of McGraw-Hill Education.
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Meet the Author
Charles D. Ellis (Greenwich, CT) served for 28 years as managing partner for Greenwich Associates, the global leader in strategy consulting to professional financial service firms. He has consulted with the world’s leading investment managers and securities firms. Primarily in the United states, but also in Australia, Canada, Japan, and the United Kingdom. The author of 12 books and more than 200 articles on investing, Ellis has taught investment courses at the Harvard Business School and the Yale School of Management.
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