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Do you believe you are, or can be, a successful day trader, buying and selling stocks on a regular basis?
Do you believe that you, or anyone you know, can successfully time the market, going in and out of the market, and consistently make profits?
You can’t, or at least not on any consistent basis over any reasonable period.
That’s the message from the new edition of Charles Ellis’ investment classic, “Winning the Loser’s Game.” First published way back in 1985, this eighth edition updates the book’s central theses: that passive investing (indexing) outperforms active investing, that investment fees are still too high, and that an understanding of behavioral economics is critical to comprehending the way people invest and behave.
Not surprisingly, Ellis says the evidence that index investing outperforms active investing is even stronger than in the last edition, published in 2016.
If you believe that there are plenty of Warren Buffetts out there who can outperform the markets, you’re also wrong. Ellis’ basic question for the average investor is this: “Can we find an investment manager who can outperform the consensus of experts enough to cover fees and costs and offset the risks and uncertainties?”
The evidence is overwhelming. When adjusted for fees and risk, most investment professionals do not outperform and are not worth the time and money.
“Active investing is a loser’s game,” Ellis says.
The fact that most fund managers underperform their benchmarks is well known, but for those not aware of how bad it is Ellis reminds us all in the first chapter: “Over one year, 70% of mutual funds underperform their chosen benchmarks; over 10 years, it gets worse: nearly 80% underperform. And 15 years later, even worse: the number is nearly 90%.”
Indexing has many other advantages: peace of mind, lower fees, lower taxes.
Are you tempted to try to time the market, or day trade? Ellis advises against it.
Market timing doesn’t work. Most of the gains in the stock market occur over very short periods of time, and if you’re not in during those times, you don’t get the gains. The problem is, no one knows when those days occur.
There are many studies that indicate the danger of not being in the market on the right days. Ellis cites one study using the S&P 500, where all the total returns over a 20-year period were achieved in the best 35 days.
Thirty-five days. That is less than 1% of the 5,000 trading days that occurred in those two decades.
The lesson is clear. “You have to be there when lightning strikes. That’s why market timing is a truly wicked idea. Don’t try it,” Ellis writes.
Stock picking doesn’t work, either. Not because those doing the picking are fools. Quite the opposite: “The problem is not that investment research is not done well,” Ellis writes. “The problem is that research is done so very well by so many … it is very hard to gain and sustain a repetitive useful advantage over all the other investors on stock selection or price discovery.”
Princeton University professor Burton Malkiel, author of another investment classic, “A Random Walk Down Wall Street,” wrote an introduction to the 8th edition where he cited a study of Taiwanese day traders conducted over a 15-year period. Less than 1% were able to beat the returns from a low-cost indexed ETF, and over 80% lost money.
Why doesn’t active investing work?
Ellis has never condemned the investment management community. He goes to great lengths to praise the industry for its dedication and hard work.
The problem, Ellis says, is not one of active deception but mathematics and probabilities. There are at least three issues that work against the active trader:
- Institutional traders have become the market. There are so many dedicated professionals with access to enormous information and computing power that it is difficult for any one member of the group to do better than the markets over long periods of time.
- Fees and the cost of trading make it almost impossible to outperform the market. This was one of Vanguard founder Jack Bogle’s central insights. Talented active managers who do have a modest edge do not outperform because the cost of trading and the high fees erode any outperformance.
- The future does not look like the past. Even if you can find an investment manager who has outperformed for a few years he or she is unlikely to continue that run. “Managers who have had superior results in the past are not particularly likely to have superior results in the future,” he writes.
The conclusion: “Active management costs more than it produces in value added. No systematic studies support an alternative view.”
How to win the loser’s game
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What’s an average investor to do? How to win at this loser’s game?
Don’t play it. Have a firm understanding of your own risk profile and stick, for the most part, with index funds that track the market.
More important than understanding the market is to understand who you are. “If you don’t know who you are, this is an expensive place to find out,” Adam Smith famously wrote in The Money Game.
Ellis’ key insight for investors is this: The winner is the person who makes the fewest mistakes. To make the fewest mistakes, focus a little less on returns and more on managing risk, particularly the risk of serious permanent loss.
The key to investment risk is to stay broadly diversified.
The key to investor risk — reducing mistakes that you are likely to make as an investor — is to understand your own foibles and biases: “Our internal demons and enemies are pride, fear, greed, exuberance, and anxiety,” Ellis writes.
You can cut down on investor risk by determining realistic investing objectives, designing a long-term strategy and sticking with it.
Sticking with a long-term strategy and not getting spooked by short-term fluctuations in the market is the hard part. Long-term investors care about a future stream of earnings and dividends, and how they are growing or shrinking. Short-term traders don’t care about earnings or dividends; they care about investor psychology that can swing wildly from day to day and month to month.
You have to be there when lightning strikes. That’s why market timing is a truly wicked idea. Don’t try it.
author of “Winning the Loser’s Game.”
“Like the climate, the average long-term investing experience is never surprising. But like the weather, the short-term experience is frequently surprising,” Ellis writes.
To avoid getting sucked into doing something you are uncomfortable with, Ellis advises investors to determine the intersection between their zone of competence and their zone of comfort.
Your zone of competence is the area you feel you have some skill. Not comfortable picking stocks or funds, or investment managers? Stay with index funds.
Your zone of comfort is where you feel calm and rational. Don’t feel comfortable with 90% of your money in stocks? Bring it to 60% or whatever level you are comfortable with.
The place where those spheres overlap is your investing sweet spot.
In a new chapter, Ellis notes that while bonds are a good diversifier and may help you feel less anxious, the fact that long-term bonds yield less than 2% and inflation is at 2% makes bonds a very unappealing investment. “Not a good investment when you get no real [inflation-adjusted] returns,” Ellis warns.
Whatever you do, stick with it. “Don’t go outside your zone of competence because you’ll make costly mistakes,” he writes. “And don’t go outside your comfort zone because you may get emotional and being emotional is never good for your investing.”
There aren’t many investing classics: This is one of them
In my 31 years covering markets for CNBC, I’ve read a lot of investing books.
But as the years go by there’s only a very small group have had an enduring influence on my thinking and that I turn to time and again.
“Winning the Loser’s Game” is one of them.
The others include “A Random Walk Down Wall Street” by Burton Malkiel, “Common Sense on Mutual Funds” by Vanguard founder Jack Bogle (almost anything by Bogle is worth reading), and “Stocks for the Long Run” by Wharton professor Jeremy Siegel.
For understanding behavioral economics, I would add “Irrational Exuberance” by Robert Shiller and “Thinking Fast and Slow” by Daniel Kahneman. To understand why experts are so wrong in their forecasts and why the future is so difficult to figure out, Philip Tetlock’s “Expert Political Judgment: How Good Is It? How Can We Know?” as well as his follow-up book “Superforecasting: The Art and Science of Prediction.”
Read these books, understand their message, and you will have a solid foundation for a lifetime of investing.