Finance
The Loser's Game That Can Make You a Winner
Sound Mind Investing offers two core investing strategies, each with a different approach.
Fund Upgrading is an "active" strategy. Seeking to earn better returns than those provided by the overall market, Upgrading involves selling lagging funds and buying better-performing funds on a regular basis. In contrast, our "passive" Just-the-Basics strategy makes no effort to "beat" the market. The goal of JtB is to simply mimic the broad market as closely as possible, accepting whatever returns the market earns.
Both strategies have built solid long-term performance records, but Upgrading has been the better performer of the two, with 10-year returns (calculated on a January-December basis) about 2.5 times larger than JtB. Still, in any given year Just-the-Basics can outrun Upgrading, as it did in both 2009 and 2010.
Don't assume that Upgrading's better performance over the long haul is because "active" strategies are inherently superior to "passive" ones. Indeed, Upgrading's outperformance is somewhat rare among actively managed approaches. The closely guarded 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 overall market.
Traditional money management has been premised on the questionable assumption that professional managers can consistently beat the market through research, intelligent risk-taking, and exploiting the mistakes of others. This assumption has largely been proven false. For many investors, therefore, the secret to winning the money game may be in not trying to win.
TENNIS LESSON
Let's look at an analogy from the world of tennis. In the 1970s, a well-known electrical engineer named Simon Ramo wrote a book on tennis strategy for amateurs: Extraordinary Tennis for the Ordinary Player. Ramo described an approach called the "loser's game."
By this he meant a type of competition in which the winner is determined by the behavior of the loser. For an amateur player, Ramo argued, the key to winning was not so much in trying to overpower one's opponent, but rather in letting the opponent defeat himself by making mistakes that lose points.
Ramo contrasted this "loser's game" approach for amateur players with the "winner's game" played at the professional level. In pro tennis, spectators 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 that amateurs lose points, 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% of the points are won due to superb offensive execution — a winner's game. On the other hand, in amateur tennis about 80% of the points are lost due to unforced errors — a loser's game.
What does this have to do with selecting a mutual fund portfolio? In his highly acclaimed book Winning the Loser's Game: Timeless Strategies for Successful Investing, money manager Charles D. Ellis applied Ramo's work to the investing arena. When Ellis studied the investment markets, he saw that it was common for 80% of the managers of stock and bond mutual funds to underperform their respective markets! In their efforts to "score" for their shareholders, they were regularly doing the investing equivalent of hitting the ball out of bounds or into the net. Trying to win, they were losing. It appeared that investing had become a loser's game.
According to Ellis, it hasn't always been this way:
The "money game" we call investment management evolved…[into] a loser's game because a basic change has occurred in the investment environment …
No longer is the active investment manager competing with cautious custodians or amateurs…out of touch with the market.… Today's money game includes a formidable group of competitors. Several thousand institutional investors — hedge funds, mutual funds, pension funds, and others — operate in the market all day, every day, in the most intensely competitive way.
The key question under the new rules of the game is this: How much better must the active mutual fund investment manager be to at least recover the costs of active management?… Recovering these costs is surprisingly difficult in a market dominated by professional investors who are intensely competitive, extraordinarily well informed, and continuously active …
[V]ery few investors have been able to…beat the market consistently over the long term, particularly after covering all the costs...of "playing the game."
Believing that investment management has become a loser's game, Ellis draws 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.
Most investors, however (either consciously or unconsciously), are caught up in playing a winner's game. Trying to beat the market, they buy financial magazines and investment newsletters that offer a dizzying array of stock and mutual fund recommendations. They feel as though they must respond to fast-breaking news events and trade with a short-term perspective. They work harder and 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 certainly more 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 yield returns similar to the market as a whole.
NICE 'N' EASY DOES IT
An investment strategy based on indexing offers distinct advantages — chief among them is the minimal effort required to set up a simple portfolio. Maintenance is easy too, since all the portfolio needs is occasional (usually annual) rebalancing. Another advantage is that an investor can know that by merely following the market, he or she is likely to outperform the majority of actively managed mutual funds over the long term!
Although no one knows for sure what the future holds, it is possible that the relative strength of indexing may grow stronger still if large-company stocks — which have underperformed stocks of smaller companies for more than a decade — come back into favor. Most indexes are designed so that the performance of larger stocks accounts for a greater share of an index's movements than the performance of smaller stocks. So if large-company stocks regain their performance edge, these larger-stock holdings will increasingly drive index performance, making it all the more difficult for active approaches to outperform indexing.
Such a phenomenon occurred in the early 1970s with the "Nifty Fifty" and again at the end of the 1990s' bull market. Whether this index-friendly scenario will happen again (and if so, when) isn't known. But if it does occur, index investors — including those following our Just-the-Basics strategy — will be the happy beneficiaries.
Although Sound Mind Investing remains convinced that Upgrading is likely to offer the more profitable path over the long term for those willing to keep up with a more active strategy, we believe Just-the-Basics has proven superior to most other investment possibilities — and if large stocks come back into favor, JtB could be even more formidable.
Just-the-Basics is particularly well-suited for investors who have retirement plans that include index funds but offer only a few actively managed funds. Upgrading can be difficult to implement in such situations because it requires access to a variety of top-performing active funds. (To learn about a modified approach for Upgrading in a 401(k), see Choosing Funds in Your 401(k) When Your Options Are Few.) Likewise, JtB is a good choice for 529 college-savings plans because such plans allow fund changes only once a year.
In summary, SMI's Just-the-Basics strategy, while not offering the long-term profit potential of Upgrading, is an approach that more than holds its own against most active strategies. And it is simple enough for anyone to apply successfully.
Learn more about JtB here.
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