Thursday, May 13, 2010

Winning The Loser’s Game

Winning The Loser’s Game, by Charles D. Ellis, is one of the books on my recommended reading list. It’s not the first book I’d recommend for a novice investor, but it’s definitely worth a read if you’re serious about learning about investing. I don’t own it, but recently checked it out of the library to re-read, and thought I’d share a few key points from the book.

The investment landscape has changed radically since the first half of the 20th century. As of the 1970s, 90% of investment transactions are done by institutions employing highly skilled professionals competing fiercely against each other. Investing has been transformed from a winner’s game to a loser’s game.

A loser’s game is one in which the winning strategy is to make fewer mistakes (i.e., lose less). Ellis uses tennis to illustrate. Professional tennis is a winner’s game, where making great shots is an important aspect of winning. By contrast, a scientific study found that amateur tennis players won more not by making great shots, but by playing defensively and making fewer mistakes.

Since research has shown that even most professionals fail to beat the market in the long run, it’s highly unlikely that amateur investors will be able to do so. So instead of trying to beat the professionals at the losing game of investing, the winning strategy is simply to own the market using low-cost index funds.

Ellis stresses the importance of having an investment policy, preferably written. The investment policy should be the foundation for constructing and managing investment portfolios. Investment policy is long-term, and helps guide investment decisions when short-term market events are most distressing;  “Policy is the most effective antidote to panic.”

Being human, our reactions to market movements are exactly the opposite of what they should be. “We are wrong when we feel good about stocks having gone up a lot, and we are wrong when we feel badly about stocks that have gone down in price.” After stock prices have gone down a lot, long-term expected returns are higher, and after they’ve gone up a lot, long-term expected returns are lower. To have the opportunity to buy low, stock prices must fall.

Investors who have studied and understand the long history of stock markets know that sudden, frightening losses in portfolio value will occur periodically. We know that it will happen, but we don’t know when.

Most individual investors worry too much about short-term fluctuations in portfolio value, and not enough about the long-term devastating effects of inflation.

Ellis poses the following classic test, which is widely quoted in other investment books. Answer the following question before reading ahead.

Question: If you had your choice, which would you prefer?
Choice A: Stocks go up by quite a lot and stay up for many years.
Choice B: Stocks go down by quite a lot and stay down for many years.

If you are like most investors, you chose choice A, but if you will be a net buyer of stocks for many years, this is not in your best interest. If stocks go down, the dividend yield will be higher, you can acquire more shares for your investment dollars, and thus you will receive a higher return from dividends. Over many years the larger dividends paid on more shares bought at lower prices will more than make up for the initial decline in your portfolio value.

Ellis also covers much of the ground covered by the other investment books I recommend, and that I’ve touched on in previous blog posts.

3 comments:

  1. This is definitely something all of us need to be reminded of .... constantly. Now why would anyone invest in high-cost funds? I'm not really a "professional tennis player"....so is there such thing as high-cost funds and reasons people may invest in those?

    This would have been a good blog to add a visual....e.g. a long-term graph to show how dividends yield more of a return with a low market....

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  2. Most actively managed funds are high-cost, and unfortunately even some index funds are high-cost. People invest in high-cost funds either because they don't know better, or because they are the only options in their 401(k) plans (unfortunately, your 401k plan is an example).

    Most mutual fund companies, stock brokers, insurance sales people, and other finance professionals who work on commission push high-cost funds because they make more money on them. Unless investors make the effort to become educated about investing, they are at the mercy of the financial industry and media that are primarily interested in making money from the investor rather than for the investor.

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  3. It’s really a nice and helpful piece of information. I’m glad that you shared this helpful info with us. Please keep us informed like this. Thanks for sharing.

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