Charley Ellis recognized that there were two different games being played in the stock market. The game the experts play differs from the game the amateurs play.
When the amateurs try to play the experts’ game they frequently make mistakes and lose money. That’s not to say the experts are fantastic at making money. A few are but experts, on average, fail to beat the market too. So the majority of experts fall short of the market and the amateurs, emulating experts, do worse.
Ellis’s solution is to play a different game entirely. The game amateurs should play, and many experts too, is built on a foundation of avoiding errors. Essentially, not losing. Fewer errors lead to better results.
Ellis wrote this in his 1975 classic The Loser’s Game. In it, he used an analogy between tennis and investing. It turns out there are two different games in tennis too. The game the professionals play is not the same game as the one the amateurs play.
The pros can be aggressive. They have the skill, precision, and experience to place shots just outside their opponent’s reach. They play a winner’s game. The match goes to the player who earns the most wins.
Amateurs, however, often lose by trying to play like the pros, because it leads to unforced errors. It’s a loser’s game. Amateurs win in tennis by volleying until their opponent hits it into the net or out of bounds. They win by not losing.
Of course, the concept of loss avoidance has been around forever but Ellis’s analogy delivers a strong message. It’s a piece every investor should read every few years.
And many of Ellis’s teachings since then follow the concept of winning by not losing.
On the Loser’s Game
Generically, a loser’s game is any game, contest, or activity in which the ultimate victor is determined by the actions of the loser. These contests are not won; they are lost. Amateur tennis is a classic loser’s game, because most points and most matches are not won. They are lost. You keep hitting balls back to me, but I double-fault or hit shots out or into the net until the set is over, and you are the winner. But you didn’t control or determine the outcome by playing better; I produced the outcome by playing worse.
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Almost all of the really big trouble that you’re going to experience in the next year is in your portfolio right now; if you could reduce some of those really big problems, you might come out the winner in the Loser’s Game.
On the Best Investment Policy
Know your own financial situation. Know your long-term goals. Know what your limits are. But be careful. Most people approach investments as if the right “solution” were mathematical, and their investment objectives rational. The objective factors are usually not the most important parts of the “best” investment policy. Experience teaches that the subjective and emotional factors are usually more important because the emotional errors — buying too high because of excessive confidence or selling too low because of excessive anxiety — do more harm than rational errors. So you need to know as well what is your emotional situation and what are your emotional constraints. What riskiness can you live with and live through? Can you hang on when the pressure is most intense and the data most compelling that you are clearly wrong? If not, recognize your own emotional realities and learn to live well within them.
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If you are not able to sit down and write out in an hour’s time what you are trying to do with your portfolio and how you intend to do it…you should at least consider making a serious study of your objectives, your risk aversion, the nature of the capital markets, your cash inflow and outflows, and the design of an investment policy that is truly right for the long term, for you.
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Three parts of investment policy are important:
- Deciding the right asset mix for the particular investment fund.
- Accepting and working with the reality that each investor’s long-term gross returns for each asset class will very likely be “average” for that asset class — minus manager fees, taxes, and so on — and accepting the corollary reality that underperforming is much more likely than outperforming.
- Sustaining policy commitments at market highs and at market lows, exactly when that rascal Mr. Market is doing his very best to do his worst.
The reality is that “roughly right” is all we can ever hope for on long-term asset mix, because even the most sophisticated investors must make their judgments on the basis not of facts, but on probabilistic estimates of two great uncertainties, markets and human reactions to markets, and without knowing the consequential leads and lags that will surely be part of the real world.
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The really hard part about investment policy is not figuring out the best feasible combination. While it takes some time and analytical discipline, this part of the problem-solving is far from advanced science.
The really hard part is managing ourselves: our expectations and our interim behavior. Walt Kelly’s Pogo puts it as “we have met the enemy and he is us.” Most investors are too optimistic about the long run and much too optimistic about how well they will do compared to the averages, so they set themselves up for disappointment.
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I don’t remember the exact year, maybe 2005 or 2006, David Swenson and I were having lunch. I said, “David, this is going to surprise you but I’m concerned that you may be too careful, too defensive, too protective. I just wonder; should you be a little bit more assertive and take a little more risk?” He said, “Honestly, I don’t know. But I do know one thing. Just about the time you think there’s never going to be a horrific negative surprise, one comes barreling along. I may be too careful. I may be too protective. I may be too defensive. Though knowing history, I think it’s probably a pretty good idea.” …
There’s a lot to be careful about. Many see “be careful” as not doing things that are bold or courageous or creative. That’s not the right way to be careful. You should be bold, creative, and courageous, but disciplined and know exactly what you’re doing.
On Luck
Every investor should recognize the powerful potential impact of luck — not good luck, but bad luck. We can all live through good luck. But bad luck — the apparently random occurrence of adversity — is equally prevalent, and its consequences can be far greater.
On Getting Excitement Out of the Market
Go to a continuous-process factory sometime — a chemical plant, a cookie manufacturer, a place that makes toothpaste. Everything is perfectly repetitive, automated, exactly in place. If you find anything interesting, you’ve found something wrong.
Investing is a continuous process too; it isn’t supposed to be interesting. It’s a responsibility. If you go to the stock market because you want excitement, then sooner or later you will lose. Everyone who thinks the stock market is a game loses — everyone, to the last man, woman, and child. So, the purpose of an investment policy is simply to ensure that your continuous process never breaks down.
On Not Losing
In investing, losing means taking decisive action at the worst possible times — being driven by your emotions precisely when you need to be the most rational.
Trying too hard to win eventually means losing. To win the Indianapolis 500, you first have to finish the Indianapolis 500 — that’s five hundred laps around and around that oval. If you try too hard on just one lap, you won’t live to finish. And just think about the Forbes 400. The turnover on that list is incredible. So many fortunes have been snuffed out by the temptation to try harder.
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All investors of course will experience uncomfortable fluctuations in the market. That’s reality — and not a major concern. The real concern is with irreversible losses caused by overreaching for speculative possibilities; by taking market risks greater than our capacity to endure turbulence and maintain consistent rationality; by reaching for managers whose best performance is behind them and who are destined or doomed to underperform — with your money; and by going into debt.
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If, as investors, we could learn to concentrate on wisely defining our own long-term objectives and learn to focus on not losing as the most important part of each specific decision, we could all be winners over the long term.
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While all the chatter and excitement is taking place about big stocks, big gains, and “three-baggers,” long-term investment success really depends on not losing — not taking major losses.
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Really strong defense makes the offense easy. Most of the trouble in investment management is not because you came just a little short of having superb investment results. It’s because you made a mistake. Knowing how to be selective, you avoid the mistakes.
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We investors make many mistakes when we make our investing decisions: we tend to buy high and sell low and we go for the mutual funds with the best two- or three-year record. The fact that past performance has no predictive power never occurs to us. It looks like a winning proposition.
On Over-Confidence
In a rapidly rising market, the faster you trade, the better you’ll do — and that makes you forget that those whom the gods would destroy, they first make confident. The more you know, the higher the odds that you’ll make a serious mistake. That’s why it’s not the beginners who tend to die at skydiving and why most car accidents happen within a few miles of home. There’s a saying in the British Royal Air Force that investors need to remember: “There are old pilots, and there are bold pilots, but there are no old, bold pilots.”
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As human beings, particularly if we are successful in other parts of our lives, we are notoriously unable to accept the obvious reality that, on average, we are average, and that our normal experiences will usually be about average because we are, as a group, captives of the normal distribution of the bell curve. It amuses us that Lake Wobegon’s children are all above average, yet studies all the time show we think we are above-average drivers, above-average parents — and above-average investors. And we do tend to take it personally when our stocks go way up or go way down, even though, as Adam Smith admonishes, “The stock doesn’t know you own it.”
On Mr. Market
The mistake most people make is answering the door just because Mr. Market knocks. You don’t have to let him in. Why should you buy just because he’s excited? Why should you sell just because he’s down in the dumps? A long-term investor shouldn’t care about market prices.
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When that seductive fellow Mr. Market comes around, you have to pay absolutely no attention to him, no matter what happens. You have to control your emotions, and most of the time that means the best thing to do is nothing. If you can’t control your emotions, being in the market is like walking into a heated area wearing a backpack full of explosives.
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Mr. Market persistently teases investors with gimmicks such as surprising earnings, startling dividend announcements, sudden surges of inflation, inspiring presidential pronouncements, grim reports of commodity prices, announcements of amazing new technologies, distressing bankruptcies, and even threats of war. These events come from his bag of tricks when they are least expected. Just as magicians use deception to divert our attention, Mr. Market’s very short-term distractions can confuse our thinking about investments.
This post had been updated; originally published on August 12, 2022.
Sources:
- The Loser’s Game
- Investment Policy and the Competent Stranger
- The Winner’s Game
- Wall Street’s Wisest Man
- Investing Success in Two Easy Lessons
- Words from the Wise Charles Ellis
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