Saturday, April 14, 2012

Don’t Play 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 ultimately contended 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). 

Interestingly, legendary value investor Benjamin Graham voiced a similar opinion in a 1976 interview that was moderated by none other than Ellis. In the interview, Graham lamented that "in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive (research) efforts will generate sufficiently superior selections to justify their cost."

Unfortunately, the rise of the institutional investor has continued unabated in the four decades since Ellis’s article. Today, institutional investors (hedge funds, mutual funds, endowments, etc.) own about 70% of the market -- about twice as much as in 1975. 

*Source: Wall St. Journal

Time to throw in the towel?

If anything, then, Ellis’s thesis that money management is a loser’s game is even more disconcerting to investors today. Nevertheless, the quest for beating the market remains a popular one. A quick search for the phrase “beat the market” on Amazon, for example, turned up 236 books with the phrase in the title, so the quest to beat the market is indeed alive and well.

However, with legions of smart hedge fund and mutual fund managers dominating the market, it’s completely reasonable for investors to conclude that the odds are stacked against them and simply buy an index fund.

But allow me to alter the premise for a moment. Should the individual investor even care about beating the market? In other words, does it have to be an "A or B" situation (try to beat the market or surrender to it)?

Institutional investors don't have much of a choice in whether or not they benchmark performance against the market as it's their primary means of marketing and attracting assets; however, for the individual investor, there are no such obligations.

Indeed, obsessing over short-term relative performance to the market will only lead the individual investor to make more trading decisions, which means higher trading costs and the potential for more mistakes. Instead, investors should think about beating the market only as an afterthought and only over longer periods of time (at least rolling five year periods). 

Out of sight, out of mind.

If you're like me, when you make an investment you don't care so much how your investment is doing relative to the market -- you only care that the investment goes up. If the market goes down 30%, for instance, it's no consolation that my stock is "only" down 15%. As the saying goes, you can't spend relative performance. 

Rather than setting your investing goals against the market, a far healthier approach might be setting a measurable, realistic, and absolute objective for yourself, such as:
  • Avoid permanent losses by demanding at least a 15% margin-of-safety on all investments with a goal of profitably closing at least 75% of all positions.
  • Produce high levels of recurring income by purchasing undervalued dividend-paying stocks with a goal of realizing a 3% initial yield and 7% annualized dividend growth.
  • Aim to own some of the market's best-performing stocks over the next decade by making equal-sized small bets on a wide number of small companies that have at least 15% insider ownership and double-digit revenue and earnings growth rates over the last three years.
These are just examples, but whatever your objective may be, I believe that you'll not only stand a better chance at realizing satisfactory returns if you set yourself a customized objective, but that five, ten, fifteen years from now when you look back at your relative performance versus the market, you'll be quite pleased with the results. 

The sign of a sound investment strategy might just be one in which you can look back and see that the market had very little to do with your success. 

Play to your strengths

To give yourself the best chance at obtaining satisfactory long-term returns, Ellis offers a few excellent tips.

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.

David didn't slay Goliath by playing on Goliath’s game on the giant's terms, nor should you play the institutions' game on their terms. Staying patient, keeping a long-term mindset, and establishing an alternative strategy 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 to 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 answer the question “What’s the market’s selling strategy?” 

The average mutual fund turnover ratio is near 100%, meaning that the average stock in the average fund is typically held for one year. With that in mind, we’re presented with two options -- hold our stocks for less than a year (and we know we’re unlikely to win that game) or hold them longer than a 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 30% above your fair value, 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 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. And if you beat the market, all the better.

What do you think? Please post your comments or criticisms below.



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