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David Fulton is a Colorado Springs, CO fee-only financial planner providing Hourly and On-Going Financial Planning and Investment Management. While he works with a broad range of clients, David specializes in working with Active and Retired Military, Federal Employees, and Families with Special Needs Children.
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Imagine you play tennis. You are probably an amateur; a weekend warrior. Perhaps you played in High school, or maybe even college. Or you might have picked up the game to work on your general health and fitness level and joined the 18 percent of the population in the U.S. who regularly play the game. Conceivably you may have joined a tennis club or a city team to better your skills, play against tougher competition, and ultimately get the most out of the sport. If so, you probably have invested in a quality racket, and hired a coach or tennis pro to help improve key components of your game.
Even with the incremental improvements afforded diligent practice, good coaching, and quality gear, you are still likely considered only an amateur in the sporting world. According to academic research there are two kinds of games in tennis; those games played by professionals, and those played by the rest of us. The rackets, courts, nets, shoes, rules, and scoring are all the same between the two games. While the conditions are the same, the outcomes are significantly different.
In his seminal investing book Winning the Loser’s Game, Charles Ellis uses this analogy of tennis to brilliantly highlight the challenges facing most investors. According to Ellis, amateur tennis is considered a “Loser’s Game”. That is not to say amateur tennis players are losers, rather it is the person that makes the fewest mistakes that typically wins the game. Thus, the outcome is determined by the mistakes made by the loser, rather than the shots made by the winner.
Conversely, in professional tennis the outcome is determined by the actions of the winner. Pros can put the ball wherever they want. Rallies go on until one player is able to take advantage and drive the ball to a perfect spot just out of reach of their opponent. Amateur tennis, on the other hand, is just the opposite. Amateurs rarely beat their opponents. Instead their opponents beat themselves, and the game is determined by the loser who makes the most mistakes over the course of the game; who hits the ball into the net, or out-of-bounds, or whose serve is consistently too high.
According to Ellis, investing in the stock market is a Loser’s Game too. That is, the person who wins at investing tends to make the least mistakes. A winning investment strategy then is really just about not losing, and not losing is incredibly important for achieving your savings goals. Too much is riding on our investing skill. But to be successful, we must first “win the loser’s game”. But don’t worry, it is generally easier than you may think.
The Efficient Market
The market is a zero sum affair. For you to buy a share of a stock or mutual fund you must first find someone willing to sell their shares. If you are going to win, someone else must lose. Remember that every time you buy a stock or mutual fund share you are buying it from an actual person who isn't trying to give you a good deal. Those who are selling no longer view their stock as an investment worth holding, so they choose to sell it, and lucky for them there is someone willing to buy it. While we may think we know more information than the seller, or perhaps we just have a powerful “gut feeling” that we can take advantage of a seller, the Efficient Market Hypothesis says…not likely.
The Efficient Market Hypothesis (EMH) was developed from a Ph.D. dissertation by economist Eugene Fama in the 1960s, and written extensively about by economist Burton Malkiel in A Random Walk Down Wall Street. EMH essentially says that at any given time, stock prices reflect all available information and trade at exactly their fair value at all times. Thus, all known information about investment securities, such as stocks, is already factored into the prices of those securities. According to the EMH, stocks always trade at their fair value on stock exchanges, making it next to impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. EMH assumes that current stock prices adjust rapidly to the release of all new public information. It contends that security prices have factored in available market and non-market public information. We do see significant variation in stocks because of this changing information. New information, or even just the failure to meet expectations, will often cause the price of a stock to rapidly change as the “market” reacts to this new information. It only takes a few trades for the price to accurately adjust to this new information.
If EMH is true, then it is impossible to consistently choose stocks that will beat the returns of the overall stock market. Basically, the hypothesis implies that the pursuit of market-beating performance is more about chance than it is about researching and selecting the right stocks. For an expert to “beat the market” they must be able to take advantage of the difference in the price that a stock is trading at versus what it should be trading at. They must be able to find an inefficiency they can exploit, and the difference between the two prices leads to increased profit. According to EMH it should be all but impossible to consistently outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments.
Markets are considered to be efficient because institutional and professional investors are so well-informed. Institutions such as pension funds, mutual funds, and skilled investment teams are highly paid, intelligent, hard-working and have deep pockets. It is unlikely that equally highly paid, intelligent, and hardworking investors from the other firms don’t know the valuation of a stock. As a result, their ability to “beat the market” is unlikely. As Larry Swedroe suggests, in order to win the game you must not only believe that your opponents view on a stock price is wrong, but you must believe the entire collective wisdom of all investors is wrong and you are right.
What We Are Up Against
Ellis call’s investing the “Loser’s Game”, because, as individual investors we are like an amateur tennis player all the sudden showing up to play Serena Williams at Wimbledon. Like facing Serena, we don’t stand a chance going toe-to-toe with the professional and institutional investors.
50 years ago investing in the stock market was considered a winner’s game. 90% of the participants were individual investors and someone who was willing to take the time and effort to really study could possibly beat the market because they were going up against mostly amateur investors. Today professional investors have become so numerous, so skilled, and so tech savvy that they now make up 80% of the market.
When you trade stocks, mutual funds, or ETFs, you are likely trading with a professional who spends 60-80 hours a week, with an incredibly deep research department behind him, doing something you may do once or twice a month. It isn’t that active mutual fund managers stink at what they do, rather, they are actually entirely too good and there are too many of them for anyone to win. Investing has changed from a winner’s game to a loser’s game. As a result, over the past 20 years more than four out of five of the pros got beaten by the market averages. The odds of an amateur individual investor beating the market is negligible, outside of sheer luck.
As Mr. Ellis points out, "Most of the managers and clients who insist on trying to beat the market, either on their own or with professional managers, will be disappointed by the results. It is a loser's game."
What Individual Investors Can Do
First; don’t lose. Ellis uses a great analogy here; think of investing like driving a car, or flying an airplane. "As all grandparents and most parents know -- and as most grandchildren will come to know -- the real test of a good driver is simple: no serious accidents. And as all flyers know, safe, dull -- even boring -- is the essence of a good flight. The secret to success in investing is not in beating the market any more than success in driving is going 10 MPH over the posted speed limit. Success in driving is being on the right road and moving at a reasonable speed."
Don’t lose. Listen to George Soros…not about politics…rather about his view on investing. “If investing is entertaining, if you're having fun, you're probably not making any money. Good investing is boring." Just like the metric used to determine a successful pilot or successful driver, the goal of a successful investor is to not lose. Most of your investment returns will not be from your investment choices, but rather from your choices you make as an investor.
As Carl Richard’s points out in his book The Behavior Gap, there is a difference between investment returns and investor returns. Studies have shown the difference between the returns investors have earned over time are lower than the returns the investment is producing. Dalbar’s 2015 Quantitative Analysis of Investor Behavior found the average mutual fund investor has under-performed the market over ever time interval they examined. Not once did the investor get the returns the market said they should be getting. Take a look at this chart from Dalbar. The difference between the S&P500 and the average investor returns are remarkable. This shows that most of us are terrible investors.
As any behavioral economist will tell you, humans are irrational creatures, and we do dumb things that are counter to our own best interest. We are heavily impacted by those around us. We listen to friends, family, neighbors, bloggers, and tv personalities while letting their emotions and logic inform our decision-making. Our expectations are driven by overconfidence and a thing called recency bias. However, when expectations fail to match reality, we panic. And panic is the worst trait an investor can have because it causes us to do dumb things like jump in and out of the market at the wrong time. Unfortunately, it is hardwired into all of us.
A Sound Investment Philosophy is Benign Neglect
Before we begin discussing asset selection and allocation or how to build an efficient portfolio, we must first understand that our investment policy, that is our vision for how we want to invest and our choices we make along the way, will account for 95% of our investment returns. Unfortunately, we typically spend most of our time arguing about the the last 5%; about what the best investment is.
Benign neglect, for most investors, is the secret of long-term success. The toughest part of investing is not figuring out the optimal investment; rather it’s sustaining a long-term focus during the inevitable market highs and lows, and staying committed to your investment policy. It turns out that outperforming your neighbor is not really about finding better investments. Investment success isn’t about skill; It’s about behavior.
Once again Ellis offers sage advice. Because this emotional aspect to investing, Ellis believes investment counseling is more important to long-term success than managing investment portfolios, and could make more of an economic difference over the long-term. Sadly, most investors will neither do the disciplined work of formulating sound long-term investment policies for themselves nor pay for investment counseling or financial advice to help them develop one.
Just Don’t Lose, A Case For Index Funds
Once you are committed to investing, and sticking to an investment policy, only then should you spend time figuring out what that strategy should be. Fortunately, the EMH plays to our favor. The vast majority of investors will never beat market averages because the market is efficient. Therefore, all that is required of us is to simply not lose. If we just achieve the market benchmark, we will have performed better than 90% of professional and institutional investors and their billions of dollars in research. I think that is a pretty good deal.
Achieving the benchmark is relatively easy thanks to Mr. John Bogle who created the first index fund back in 1975 and forever changed the investing world. When investors buy a “passive” index fund, they get a well-rounded selection of stocks without having to purchase each stock individually. An index simply buys all the stocks in a particular market, such as the S&P 500, and tracks the performance of that index. Because we have no way of knowing which stocks will beat the market or conversely those which will not, it makes sense that you are better off buying the entire market at a very low-cost, and taking the return provided. By tracking an index, an investment portfolio gets good built-in diversification, low turnover (to keep transaction costs low), and low management fees.
As Rick Ferri points out in his book The Power of Passive Investing a passive fund strategy, coupled with prudent asset allocation (what types of assets, eg: Large-cap, small-cap, growth, value etc), provides most investors the best opportunity to meet their long-term financial goals. Low-cost index funds beat most actively managed mutual funds. The probability that an active fund will beat an index fund drops over time, and decreases as the portfolio contains more than one class of funds. The excess return from a winning actively managed fund doesn't often cover the costs associated with active management; even more problematic, winning active funds are difficult to identify in advance so determining which to pick ahead of time is very nearly impossible.
I fully recognize that index funds are not a remedy for everyone and there is plenty of criticism of this approach. However, as you plan for your future, you are going to be faced with making trade-offs; trade-offs in time, energy, effort, and resources. People spend an exorbitant amount of time trying to find the "best" investment...but there is no such thing. How much time, energy, and effort do you want to expend? After all, we are talking about the last 5% of the equation. You control 95% of the outcome by just picking an investment policy and sticking to it.
Most people don't have the resources to spend searching for a "better" investment. A passive index approach is appropriate for the vast majority of us. You don't need to find great investments, you just need to be a great investor. You do this by buying good quality investments (like an index fund) and then behave correctly. Like in amateur tennis, just focus on getting the ball on the other side of the net. You've got better things to do!
Interested in reading more about index funds?
I recommend the following books:
- Winning the Loser's Game by Charles D. Ellis
- The Only Guide to a Winning Investment Strategy You'll Ever Need by Larry E. Swedroe
- The Power of Passive Investing: More Wealth With Less Work by Richard A. Ferri