Winning the Loser's Game: Timeless Strategies for Successful Investing, Eighth Edition

By Charles D. Ellis

The definitive guide to long-term investing success—fully updated to address the realities of today’s markets

Technology, information overload, and increasing market dominance by expert investors and computers make it harder than ever to produce investing results that overcome operating costs and fees. Winning the Loser’s Game reveals everything you need to know to reduce costs, fees, and taxes, and focus on long-term policies that are right for you.

Candid, short, and super easy to read, Winning the Loser’s Game walks you through the process of developing and implementing a powerful investing strategy that generates solid profits year after year. In this eagerly awaited new edition, Charles D. Ellis applies the expertise developed over his long, illustrious career. This updated edition includes:

• NEW CHAPTERS on bond investing, how investor behavior affects returns, and how technology and big data are challenging traditional investment decisions
• NEW RESEARCH and evidence supporting the case for indexing investment operations
• NEW INSIGHTS into the role of governance, developing a comprehensive saving strategy, and the power of regression to the mean

Companies change, and markets and economies go up and down—sometimes a lot.
But the core principles of successful investing never change—and never will. That’s why, when you’ve read this book, you’ll know all you really need to know to be successful in investing.

With Winning the Loser’s Game, you have everything you need to identify your unique investment objectives, develop a realistic and powerful investment program, and drive superior results.

• Language: English
• Publisher: McGraw-Hill Education
• Release date: May 18, 2021
• ISBN: 9781264258475

Book preview

Praise for Winning the Loser’s Game

The best book about investing? The answer is simple:Winning the Loser’s Game.

—F. William McNabb III, former CEO, The Vanguard Group, Inc.

Of the thousands upon thousands of books for individual investors, perhaps a dozen are worth reading. Of the dozen, only one is written with verve and clarity. Read this classic, learn its lessons, follow its precepts and prosper.

—David F. Swenson, Chief Investment Officer, Yale University

Winning the Loser’s Game is one of a tiny handful of books that should be read by every investor. Charley Ellis has written a timeless investment classic that will be as worth reading 50 years from now as today—but for your own sake, don’t wait to pick it up.

—Seth Alexander, President, MIT Investment Management Company

A seminal work. Its true and tested investing principles, vindicated over decades of experience, provide an invaluable framework for institutional and retail investors alike. The message resonates even more powerfully in today’s world of unorthodox economic policy-making and lasting financial distortions.

—Gumersindo Oliveros, CEO and CIO, KAUST Investment Management

Investors today face one of the most uncertain and difficult investing environments in a generation. A classic is by definition timeless, a source of inspiration and guidance in every circumstance.Winning the Loser’s Game fits the mold to perfection: Its lessons for investors, and very especially individual investors, have never been more valuable than today.

—Luis M. Viceira, George E. Bates Professor, Harvard Business School

To invest well is a daunting task no matter one’s financial sophistication. It’s especially so for individual investors because their investment decisions are so closely intertwined with life circumstances and choices.Winning the Loser’s Game provides a powerful framework and clear prescriptions for establishing a game plan to deliver long-term investment success.

—Andre Perold, Cofounder, Managing Partner, and Chief Investment Officer of HighVista Strategies

No one understands what it takes to be a successful investor better than Charley Ellis, and no one explains it more clearly or eloquently. This updated investment classic belongs on every investor’s bookshelf.

—Consuelo Mack, Executive Producer and Managing Editor, Consuelo Mack WealthTrack

Selected Books by Charles D. Ellis

The Elements of Investing: Easy Lessons for Every Investor with Burton G. Malkiel

Capital: The Story of Long-Term Investment Excellence

The Index Revolution: Why Investors Should Join It Now with Burton G. Malkiel

The Partnership: The Making of Goldman Sachs

What It Takes: Seven Secrets of Success from the World’s Greatest Professional Firms

Investment Policy: How to Win the Loser’s Game

The Investor’s Anthology: Original Ideas from the Industry’s Greatest Minds with James R. Vertin

Classics I and II: Investor’s Anthology with James R. Vertin

Wall Street People I and II: True Stories of Today’s Masters and Moguls

Joe Wilson and the Creation of Xerox

Falling Short: The Coming Retirement Crisis and What to Do About It with Alicia H. Munnell and Andrew D. Eschtruth

Copyright © 2021 by McGraw Hill. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.

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For Linda Lorimer, my beloved wife and best friend. You helped make this book—and my life—so much better, more useful for others, and more fun for us.

CONTENTS

FOREWORD BY BURTON G. MALKIEL

PREFACE

1   THE LOSER’S GAME

2   THE WINNER’S GAME

3   THE GRIM REALITIES

4   BEATING THE MARKET

5   MR. MARKET AND MR. VALUE

6   INVESTOR’S DREAM TEAM

7   INDEXING: YOUR UNFAIR ADVANTAGE

8   INVESTOR RISK AND BEHAVIORAL ECONOMICS

9   THE PARADOX HAUNTING ACTIVE INVESTING

10   TIME: ARCHIMEDES’ LEVER

11   INVESTMENT RETURNS

12   INVESTMENT RISKS VERSUS UNCERTAINTY

13   BUILDING INVESTMENT PORTFOLIOS

14   WHOLE-PICTURE INVESTING

15   MORE ABOUT BONDS

16   WHY POLICY MATTERS

17   PLAYING TO WIN

18   CHALLENGES OF PERFORMANCE MEASUREMENT

19   ACTIVE INVESTING’S FAILURES

20   PREDICTING THE MARKET—ROUGHLY

21   INDIVIDUAL INVESTOR DECISIONS

22   SELECTING MUTUAL FUNDS

23   PHOOEY ON PHEES!

24   PLANNING YOUR PLAY

25   DISASTER AGAIN AND AGAIN

26   GETTING OK ON YOUR 401(k) PLAN

27   YOUR ENDGAME

28   THOUGHTS FOR THE WEALTHY

29   GOOD TO GO!

30   PARTING THOUGHTS

A   INVESTMENT COMMITTEES AND GOOD GOVERNANCE

B   MURDER ON THE ORIENT EXPRESS

C   RECOMMENDED READING

INDEX

FOREWORD

METAPHORS CAN HAVE POWERFUL INFLUENCE ON HOW WE THINK and act and can have enormous impact on real world outcomes. Metaphors can move minds and markets. To take one well-­known example, Adam Smith’s invisible hand had a major effect on economic thought and became the essential intellectual foundation for free-market capitalism.

Charley Ellis has created a metaphor that has enjoyed a similar kind of influence on investment management.Winning the Loser’s Game was first released in 1985, although the germ of the idea was published in a professional article a decade earlier. Using the game of tennis as an example, Ellis shows that amateur tennis players are often their own worst enemies. When playing against other amateurs, the winner is not usually the one with the best drop shot or most powerful serve, as in professional matches. Rather, it is the player who makes the fewest unforced errors. Thus the best strategy is simply to try to return the ball and wait for the other player to make a mistake.

By analogy, the optimal strategy in investing is to avoid trying to beat the market. The successful investor simply buys and holds a broad-based index fund that contains all the stocks that are available and waits for Mr. Market eventually to reflect the growth in the economy. Actively buying and selling shares involves extra costs and higher taxes and is very likely to lead to unforced errors.

As markets have developed over time and new editions of the book have come out, it has become increasingly clear that the Ellis advice is applicable for most professional investors as well as amateurs.

A century ago, over 90 percent of the trading on our stock exchanges was done by individuals. In such a market, professionals with quicker access to information could hope to gain an advantage over unsophisticated investors and outperform a passive index fund. But over time it has come to be the case that most individuals invest in mutual funds and exchange-traded funds with institutions that run their retirement plans, and over 90 percent of the trading is now done by professionals. In this environment, outperformance is likely to be very rare, even for the most skilled professionals.

In this new edition of Winning the Loser’s Game, Ellis documents that the vise of data is now tightening, and new evidence reveals that the thesis of earlier editions holds with even greater force. Standard and Poor’s has become the unofficial scorekeeper of investment performance. Publishing semiannual SPIVA reports, the company documents how active managers have performed versus broad S&P stock indexes. The data show that each year over two-thirds of managed funds are outperformed by the broad S&P 1500 stock index. Moreover, those active managers who outperform in one year are not the same as those who beat the market in the next. When one examines 15-year records of professional money managers, over 90 percent must hold their heads in shame versus a low-cost, broad-based index. Moreover, the percentage of active investors who outperform the market has been steadily falling over time. Actively buying and selling individual stocks in a futile attempt to beat the market is truly a loser’s game.

Ellis’s message is particularly timely today. In this age of Covid-19, with millions sheltered at home, a pandemic of gambling has infected Americans as well as those in Europe and Asia. Sports betting is setting new records, and gambling on the stock market has become a national pastime. Zero-commission trading has prompted legions of individual investors to confuse gambling with investing and to become day traders. We have witnessed bankrupt companies quintuple in value only to fall back later to their original valuations. The most favored stocks on Robinhood (a popular online trading platform) tend to be among the riskiest and most volatile—for example, Tesla is a stock that has moved as much as 25 percent in a single day.

Several studies have documented how poorly individual traders actually do in the stock market. Barber and Odean of the University of California analyzed the active trading accounts of the discount broker Charles Schwab over a six-year period. They found that those active traders substantially underperformed a simple low-cost index fund. And the traders who traded the most had the worst returns. In another study by them, together with Taiwanese researchers, the trades of day traders in Taiwan, where the practice has been especially popular, were analyzed over a 15-year period. It turned out that less than 1 percent of day traders were able to beat the market returns available from a low-cost ETF, and over 80 percent of them actually lost money. In a study of day trading in Brazil, the results were even more devastating. Only 3 percent of day traders made money.

In this delightfully written new edition, Ellis shows that serious investing involves broad diversification, rebalancing, active tax management, avoiding market timing, staying the course, and using indexed investment instruments with rock-bottom fees. Of particular note in this update is the warning that investors need to reconsider the use of bonds during an age of financial repression. Central banks throughout the world have pushed bond yields near zero and even to negative returns in Europe and Asia. In such an environment, even if inflation remains subdued at under 2 percent, Ellis warns that bonds are hard to justify as appropriate long-term investments. With timely advice such as this, readers who follow the Ellis recommendations will significantly improve their odds of becoming winners in the investment game.

Burton G. Malkiel

PREFACE

LUCKY ME! MARRIED TO A WONDERFUL AND INSPIRING WOMAN, I WAS born in the United States; privileged in education; blessed with parents, children, and grandchildren I like, admire, and enjoy; and also blessed with an unusually wide global circle of friends in investment management—an endlessly fascinating profession in a remarkably favored business—replete with bright, engaged, and creative people.

Investing can seem way too complex, and investing wisely can seem to take too much time. Most individuals are too busy to take the time to learn all about it. They and you have better things to do.

With increasing concern, I’ve seen the long-term professionalism that attracted me to investing get increasingly compromised by short-term commercialism and growing numbers of investors worrying about the uncertainties about how to manage investments for the long term. With all my advantages comes a clear responsibility to serve others. That’s why I wrote this book.

Over the past half century, the securities markets have changed massively and in many ways, creating an overwhelming problem for individual and professional investors. Those profound changes are explained in Chapter 1, The Loser’s Game. Raised in a tradition that if you recognize a problem, you should look for a good solution, I’ve written this short book of straight talk. Each reader can understand the realities he or she faces and know how to take appropriate action to convert the usual loser’s game into a winner’s game in which every sensible investor can and should be a long-term winner.

As Winston Churchill so wisely observed, People like winning very much! We all like winning with investments, and we all can win—at lower costs, less risk, and less time and effort if we can clarify our real objectives, develop sensible long-term policies, and stick with them so the markets’ fluctuations are working for us, not against us.

In over 50 years of learning about investing from outstanding practitioners and expert theorists around the world, I’ve tried to collect, distill, and explain clearly and as plainly as possible the principles for successful investing. For both individual investors and institutional investors who have the necessary self-discipline and wish to avoid the loser’s game, the simple messages in this short book are now and will be the keys to success in the winner’s game of sensible investing for the next 50 years.

Companies change, and markets and economies go up and down—sometimes a lot. But the core principles of successful investing never change—and never will. That’s why, when you’ve read this book, you’ll know all you really need to know to be successful in investing.

Charles D. Ellis

New Haven, CT

March 2021

CHAPTER 1

THE LOSER’S GAME

DISAGREEABLE DATA ARE STREAMING STEADILY OUT OF THE COMputers of performance measurement firms. Over and over again, these facts and figures inform us that most mutual funds are failing to perform or beat the market. The same grim reality confronts institutional investors such as pension and endowment funds. Occasional periods of above-average results raise expectations that are soon dashed as false hopes. Contrary to their often-articulated goal of outperforming the market averages, investment managers are not beating the market; the market is beating them.

Faced with information that contradicts what they believe, people tend to respond in one of two ways. Some ignore the new knowledge and hold firmly to their old beliefs. Others accept the validity of the new information, factor it into their perception of reality, and put it to use. Most investment managers and most individual investors, being in a sustained state of denial, are holding on to a set of romantic beliefs developed in a long-gone era of different markets. Their romantic views of investment opportunity are repeatedly—and increasingly—proving to be false.

Investment management, as traditionally practiced, is based on a single core belief: Investors can beat the market, and superior managers will beat the market. That optimistic expectation was reasonable 50 years ago, but not today. Times have changed the markets so much in so many major ways that the premise has proved unrealistic: In round numbers, over 1 year, 70 percent of mutual funds underperform their chosen benchmarks. Over 10 years, it gets worse; nearly 80 percent underperform. And 15 years later, even worse—the number is nearly 90 percent.

Yes, several funds beat the market in any particular year and some in any decade, but scrutiny of the long-term record reveals that very few funds beat the market averages over the long haul—and nobody has yet figured out how to tell in advance which funds will do it.

If the premise that it is feasible to outperform the market were true, then deciding how to go about achieving success would be a matter of straightforward logic.

First, because the overall market can be represented by a public listing such as the S&P 500 or the Wilshire 5000 Total Market Index, a successful active manager would only need to rearrange his or her portfolios more productively than the mindless index. The active manager could choose to differ from the chosen benchmark in stock selection, strategic emphasis on particular groups of stocks, market timing, or various combinations of such decisions.

Second, because an active manager would want to make as many right decisions as possible, he or she would assemble a group of bright, highly motivated professionals whose collective purpose would be to identify underpriced securities to buy and overpriced securities to sell—and, by shrewdly betting against the crowd, to beat the market. With so many opportunities and so much effort devoted to doing better, it must seem reasonable to casual observers that experienced experts working with superb information, powerful computer models, and great skill would outperform the market—as they so often did decades ago.

Unhappily, the basic assumption that many institutional investors can outperform today’s market is false. Today, the institutions are the market. They do nearly 95 percent of all listed stock trades and derivatives trades. It is precisely because investing institutions are so numerous and capable, and so determined to do well for their clients, that investment management has become a loser’s game. Talented and hardworking as they are, professional investors cannot as a group outperform themselves. In fact, given the operating costs of active management—fees, commissions, market impact, and taxes—many active managers will underperform the overall market every year, and over the long term, a large majority will underperform.

Individuals investing on their own do even worse—on average, much worse. Day trading is the worst of all: a sucker’s game. Don’t do it, ever. Before analyzing what happened to convert institutional investing from a winner’s game into a loser’s game, consider the profound difference between the two kinds of games.

Dr. Simon Ramo, a scientist and one of the founders of TRW Inc., identified the crucial difference between a winner’s game and a loser’s game in an excellent book on game strategy,Extraordinary Tennis for the Ordinary Tennis Player.¹ Over many years, Ramo observed that tennis is not one game but two: one played by professionals and a very few gifted amateurs, and the other played by all the rest of us.

Although players in both games use the same equipment, rules, and scoring, and both conform to the same etiquette and customs, they play two very different games. After extensive statistical analysis, Ramo summed it up this way: Professionals win points; amateurs lose points.

In expert tennis, the ultimate outcome is determined by the actions of the winner. Professional tennis players hit the ball hard with laserlike precision through long and often exciting rallies until one player is able to drive the ball just out of reach or force the other player to make an error. These splendid players seldom make mistakes.

Amateur tennis, Ramo found, is almost entirely different. Amateurs seldom beat their opponents. Instead, they beat themselves. The actual outcome is determined by the loser. Here’s how: Brilliant shots, long and exciting rallies, and seemingly miraculous recoveries are few and far between. The ball is all too often hit into the net or out of bounds, and double faults at service are not uncommon. Rather than try to add power to our serve or hit closer to the line to win, we should concentrate on consistently getting the ball back so the other player has every opportunity to make mistakes. The victor in this game of tennis gets a higher score because the opponent is losing even more points.

As a scientist and statistician, Dr. Ramo gathered data to test his hypothesis in a clever way. Instead of keeping conventional game scores—15–love, 15–all, 30–15—and so forth, he simply counted points won versus points lost. He found that in expert tennis about 80 percent of the points are won, whereas in amateur tennis about 80 percent of the points are lost. The two games are fundamental opposites. Professional tennis is a winner’s game: the outcome is determined by the actions of the winner. Amateur tennis is a loser’s game: the outcome is determined by the mistakes of the loser, who defeats himself or herself.

The distinguished military historian Admiral Samuel Eliot Morison made a similar central point in his thoughtful treatise Strategy and Compromise: In warfare, mistakes are inevitable. Military decisions are based on estimates of the enemy’s strengths and intentions that are usually faulty, and on intelligence that is never complete and often misleading. Other things being equal, the side that makes the fewest strategic errors wins the war.²

War is the ultimate loser’s game. Amateur golf is another. Tommy Armour, in his book How to Play Your Best Golf All the Time, says, The best way to win is by making fewer bad shots.³ This is an observation with which all weekend golfers would concur.

There are many other loser’s games. Like institutional investing, some were once winner’s games but have changed into loser’s games with the passage of time. For example, 100 years ago, only very brave, athletic, strong-willed young people with good eyesight had the nerve to try flying an airplane. In those glorious days, flying was a winner’s game. But times have changed, and so