The Loser's Game That Can Make You A Winner
by Austin Pryor with Mark Biller
November 3, 2005
(AgapePress) - - The Sound Mind Investing newsletter offers two primary investing strategies, featuring two very different approaches. Fund Upgrading is an "actively managed" strategy, where we make investing decisions every month in our effort to earn better returns than the market obtains. By contrast, our Just-the-Basics strategy makes no effort to figure out how to beat the market. Its goal is simply to mimic the market closely and accept whatever returns the market earns.In recent years we've written often about Upgrading but only occasionally about Just-the-Basics. The main reason for this emphasis is that we believe Upgrading will produce better returns over time. That expectation of superior returns has been realized each of the past six years, during which Upgraders have earned cumulative returns six times larger than those of the overall market, and four times larger than those of Just-the-Basics. (See SMI's Performance History.)
Of course, Upgrading won't always beat the market. And it's important to realize that Upgrading is the rare actively-managed strategy that has been able to even keep up with the market's returns over an extended period of time. You see, the dirty little secret of professional investing is that most actively-managed investments -- including most mutual funds, planner/broker portfolios, newsletter strategies, etc. -- fail to keep up with the market. Traditional money management is founded on the questionable assumption that professional managers can consistently beat the market through research, intelligent risk-taking, and exploiting the mistakes of others. But that assumption has largely proven to be false.
It turns out that the secret to winning the money game may be to not try winning at all. Let's look at an analogy from the world of tennis. I have spent many an afternoon risking bodily injury and public humiliation on the tennis courts. As a beginner, I concentrated my efforts on trying to learn how to hit the ball correctly. My strategy had little to do with specific plans for hitting the ball to my opponent's forehand or backhand or placing it shallow or deep. My primary concern was pretty simple: Try to keep the ball in bounds! I lost many more points due to the mistakes I made than as a result of the actions of my opponents.
In his book on tennis strategy, Extraordinary Tennis for the Ordinary Player, Dr. Simon Ramo describes the kind of amateur tennis I play as a "loser's game." By that he means it is the kind of competition where the winner is determined by the behavior of the loser. The amateur doesn't win by defeating his opponent; he wins by letting his opponent defeat himself.
Ramo contrasted this with the "winner's game" played at the professional tennis level. In those matches, we are accustomed to seeing consistently precise serves, stunning recoveries, and long, dramatic rallies. Eventually, one player takes a calculated risk and attempts to put his opponent away with an exceptionally powerful or well-placed shot. At the expert level, it is the winning of points that drives the action and determines the outcome.
In short, Ramo observed, amateurs lose points and professionals win points. To test his hypothesis, he compiled an extensive database of points scored in actual tournaments at both levels. He found a surprisingly consistent and symmetrical tendency. In professional tennis, about 80 percent of the points are won due to superb offensive execution -- a winner's game. On the other hand, in amateur tennis about 80 percent of the points are lost due to unforced errors -- a loser's game.
OK, so what does this have to do with selecting a mutual fund portfolio? In his highly acclaimed book Investment Policy, money manager Charles D. Ellis applied Ramo's work to the investing arena. When Ellis studied the investment markets, he saw that it was not uncommon for 80 percent of the managers of stock and bond mutual funds to underperform their respective markets. In their efforts to "score" for their shareholders, they were hitting the ball into the net or out of bounds far too often. It appeared that investing had become a loser's game. According to Ellis, it hadn't always been this way:
Winner's games can and do sometimes become loser's games. That is what has happened to the "money game" we call investment management. A basic change has occurred in the investment environment; the market came to be dominated in the 1970s by the very institutions that were striving to win by outperforming the market. And that shift made all the difference. No longer was the active investment manager competing with cautious custodians or amateurs who were out of touch with the market. Now he was competing with other experts .... So many professional investment managers are so good, they make it nearly impossible for anyone to outperform the market they now dominate.
The key question under the new rules of the game is this: How much better must the active manager be to at least recover the costs of active management? Recovering these costs is surprisingly difficult. Such superior performance can be done and is done every year by some, but it has not been done consistently over a long period of time by many ....
Believing that investment management had evolved into a loser's game, Ellis drew this conclusion: Just as the path to victory in amateur tennis is to play a passive, patient game while letting your opponent take the risks, so the logical strategy for the amateur investor should be the same.
The Advantages of 'Loser's Game'
There are advantages to playing a loser's game. Most investors, consciously or subconsciously, are caught up in playing a winner's game. They're trying to "beat the market." They buy financial magazines and investment newsletters that offer a dizzying array of stock and mutual fund recommendations, and they feel they must respond to fast-breaking news events and trade with a short-term perspective. Theirs is an active strategy where they work harder and take extra risks in what is usually a futile attempt to "win."
In a loser's game, the strategy is more passive (and relaxing!). The path to victory lies in minimizing mistakes and being patient. This describes our Just-the-Basics portfolios where we refuse to play the performance game. Instead, we simply invest in selected "index" funds, which, by definition, are going to give us returns similar to the market as a whole.
An investment strategy based on indexing has many advantages to offer. Chief among them are the minimal effort required to set up a simple portfolio whose only need is occasional rebalancing, and the knowledge that by merely following the market you're likely to outperform the majority of actively-managed mutual funds over an extended period of time. Even during the past decade, which favored actively-managed funds (because they could underweight plummeting tech stocks and hold cash as the bear market set in), only 45 percent of actively-managed stock funds outperformed the S&P 500.
Compared with most other investment possibilities, simple indexing is likely to be the best option, which is why we often recommend it for those with index funds in their company retirement plans or for other investments where Upgrading isn't possible (as in college 529 plans). As we indicated earlier, we think Upgrading is likely to be the more profitable path for those willing to keep up with a more active strategy. But indexing is preferable to most other investing methods, and is simple enough for anyone to apply successfully.
Published since 1990, Sound Mind Investing is America's best-selling financial newsletter written from a biblical perspective. To see how their specific saving and investing advice can benefit you, visit them online.
