Money and Finance
Bottom line
For more on the "loser's game", a new multi-part video series by Sensible Investing addresses the topic and has a lined up a number of good interviewees. Here's the trailer.
Best,
Todd
A version of this post was published on April 14, 2012. It has been updated.
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Money and Finance
Playing the Loser's Game
In a 1975 article in the Financial Analysts Journal entitled “The Loser’s Game”, Charles D. Ellis wrote:
Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat the market averages.
Ellis concluded that the influx of smart and motivated people into the industry led to money management becoming a “loser’s game” -- a game in which you'd be crazy to compete and one that you should perhaps consider surrendering to (i.e. buy an index fund). Ellis recently reiterated this opinion in a recent article for the Financial Analysts Journal.
Time to throw in the towel?
It's natural to read these comments and get discouraged about buying individual stocks, but Ellis's 1975 article offers a few excellent tips on how to not play the loser's game.
1. Be sure you are playing your own game.
The individual investor’s advantage is not in trading. The hedge funds, mutual funds, and professional traders of the world simply have better data, more advanced trading platforms, and more financial incentive to focus on the short-term. The weekend investor doesn’t stand a chance versus this type of firepower, so trading is a game where the odds are stacked against the individual investor.
Staying patient, keeping a long-term mindset, and exploiting your advantages as an individual investor alters the playing field and improves your odds of success.
2. Keep it simple.
The less complicated your investment strategy, the better. As Ellis recommends, "Try to do a few things well." By focusing your efforts on one strategy -- whether it is based on dividends, small caps, deep value, etc -- and consistently sticking with it, you can more effectively tune out distractions and make better decisions. As a result, you'll keep trading costs down and give yourself the best opportunity to realize your return objectives.
3. Concentrate on your defenses.
Ellis advocates improving your selling strategy because the market’s focus on buying makes it difficult to gain an edge on that side of the equation. It’s a fair point.
To figure out how we might improve our selling strategy, let's consider the market's selling strategy.
While each investment firm has its own selling strategy, we know that the average mutual fund turnover ratio in recent years implies that, on average, stocks owned by funds have been held for just over one year.
Our key strength as individual investors lies in our ability to be patient, so our selling strategy should start with the idea of holding for at least three years and ideally five years or longer. Obviously if one of your stocks shoots well above your fair value estimate, it might be time to sell or trim the position, but on average we should look to hold for longer periods of time.
To figure out how we might improve our selling strategy, let's consider the market's selling strategy.
While each investment firm has its own selling strategy, we know that the average mutual fund turnover ratio in recent years implies that, on average, stocks owned by funds have been held for just over one year.
Our key strength as individual investors lies in our ability to be patient, so our selling strategy should start with the idea of holding for at least three years and ideally five years or longer. Obviously if one of your stocks shoots well above your fair value estimate, it might be time to sell or trim the position, but on average we should look to hold for longer periods of time.
4. Don’t take it personally.
According to Ellis, the market turned into a loser's game precisely because investors’ "efforts to beat the market are no longer the most important part of the solution; they are the most important part of the problem." Resist the temptation to try harder for better returns. In fact, do just the opposite. This doesn’t mean you should pick stocks at random and buy and hold forever. Do your homework, of course, but be deliberate and patient, too. Let the market go through its phases of euphoria and despair and stay your course. Don't try to force returns.
Trying to beat the market in the short-run is a loser’s game if you make it your primary investment objective, so don’t play it. Instead, redefine the game. Establish your own objectives, stick to your strengths, and stay patient and when you look back at your returns five years from now, I think you'll like what you see. If you happen to beat the market, all the better.
For more on the "loser's game", a new multi-part video series by Sensible Investing addresses the topic and has a lined up a number of good interviewees. Here's the trailer.
What do you think? Let me know on Twitter @toddwenning.
I've updated my Dividend Compass spreadsheet to fix a few bugs. You can download the updated version here.
What I've been reading this week:
- Profile of hedge fund manager Joel Greenblatt - Barron's
- How The City is overcharging investors - Monevator
- Buying insurance after a disaster strikes - A Wealth of Common Sense
- Time, not timing, is the key to investing success - Washington Post
- Don't let a single event change your investment strategy - NY Times
Stay patient, stay focused.
Best,
Todd
- Ray Dalio Quote
“The bets are zero sum. In order for you to beat me in the game, it’s like poker, it’s a zero sum game. We have 1,500 people that work at Bridgewater, we spend hundreds of millions of dollars on research, and so on. We’ve been...
- How I Got Started In Investing
Working hard is important. But there is something that matters even more, believing in yourself. Think of it this way; every great wizard in history has started out as nothing more than what we are now, students. If they can do it, why not us? -- Harry...
- Investing Wisdom From The Wire
My wife and I started re-watching one of our favorite television series, The Wire. We're through the third season now and I've been jotting down some quotes that I thought could also apply toward investing. Here's what I have so far. "Game...
- What To Do When Your Stock Plunges
Invest long enough and one morning you'll open your browser to check your stocks only to find that one of them is down 20% or more in pre-market trading. Fortunately, this sinking feeling doesn't happen often, but shareholders in a number of popular...
- Investing And Mistake Avoidance
Excellent piece by Morgan Housel hits an important topic, investment success is more about avoiding the downside than striving for blinding insight: "If it were up to me, I would replace every book called How to Invest Like Warren Buffett with a...