The latest edition of Charles Ellis’ investment classic explores why people are terrible day traders
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Do you think you are or can be a successful day trader who regularly buys and sells stocks?
Do you think that you or someone you know can successfully time the market, get in and out of the market, and consistently make profits?
You may not, or at least not on a consistent basis over a reasonable period of time.
That is the message from the new edition of Charles Ellis’ investment classic “Winning the Loser’s Game”. This eighth edition, first published in 1985, updates the book’s key theses: passive investing (indexing) outperforms active investing, that investment fees are still too high, and that an understanding of behavioral economics is critical to understanding how people invest and behave.
Unsurprisingly, according to Ellis, the evidence that index investing outperforms active investing is even stronger than it was in the previous edition, released in 2016.
If you think there are many Warren Buffetts out there who can outperform the markets, you are wrong too. Ellis’ fundamental question for the average investor is, “Can we find an investment manager who goes beyond the consensus of the experts to cover fees and costs and offset the risks and uncertainties?”
The evidence is overwhelming. When adjusted for fees and risks, most investment professionals do not outperform and are worth neither time nor money.
“Active investing is a loser’s game,” says Ellis.
The fact that most fund managers fail their benchmarks is well known, but for those who don’t know how bad it is, Ellis reminds us all in the first chapter: “Over a year, 70% of mutual funds are behind their chosen benchmarks back; over 10 years it gets worse: almost 80% below average. And 15 years later even worse: the figure is almost 90%. “
Indexing has many other advantages: security, lower fees, lower taxes.
Are you tempted to time the market or day trading? Ellis advises against it.
Market timing doesn’t work. Most of the profits in the stock market occur in very short periods of time and if you are absent during those times you will not get profits. The problem is, nobody knows when these days will occur.
There are many studies that point to the risk of not being in the market on the right days. Ellis cites a study with the S&P 500 in which all total returns over a 20 year period were in the best 35 days.
Thirty-five days. That’s less than 1% of the 5,000 trading days in those two decades.
The lesson is clear. “You have to be there when lightning strikes. That’s why market timing is a really bad idea. Don’t try,” writes Ellis.
Stock picking doesn’t work either. Not because those who harvest the crops are fools. On the contrary: “The problem is not that investment research is not done well,” writes Ellis. “The problem is that research is done so well by so many. It is very difficult to obtain and maintain a repetitive useful advantage over all other investors in stock selection or pricing.”
Princeton University professor Burton Malkiel, author of another investment classic, “A Random Walk Down Wall Street,” wrote an introduction to the 8th edition citing a study of Taiwanese day traders conducted over a 15-year period has been. Less than 1% outperformed a low-cost indexed ETF and over 80% lost money.
Why doesn’t active investing work?
Ellis never judged the investment management community. He goes to great lengths to commend the industry for their dedication and hard work.
The problem, says Ellis, isn’t active deception, it’s math and probabilities. At least three problems work against the active trader:
- Institutional traders have become the market. There are so many dedicated professionals with access to tremendous information and computing power that it is difficult for one member of the group to outperform the markets for long periods of time.
- Fees and trading costs make it almost impossible to outperform the market. This was one of the key discoveries made by Vanguard founder Jack Bogle. Talented active managers who have a modest edge do not excel as the trading costs and high fees undermine any outperformance.
- The future doesn’t look like the past. Even if you find an investment manager who has outperformed for a number of years, he or she is unlikely to continue on that run. “Managers who have had superior results in the past are unlikely to have superior results in the future,” he writes.
The conclusion: “Active management costs more than it produces added value. No systematic studies support an alternative view.”
How to win the loser’s game
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What can the average investor do? How can you win at this loser’s game?
Don’t play it. Have a firm understanding of your own risk profile and for the most part stick with index funds that track the market.
Understanding who you are is more important than understanding the market. “If you don’t know who you are, this is an expensive place to find out,” wrote Adam Smith in The Money Game.
Ellis’ key takeaway for investors is that the winner is the person who makes the fewest mistakes. To make the fewest mistakes, focus a little less on returns and more on risk management, especially the risk of serious permanent loss.
The key to investment risk is staying broadly diversified.
The key to investor risk – reducing the mistakes you are likely to make as an investor – is understanding your own weaknesses and prejudices: “Our internal demons and enemies are pride, fear, greed, exuberance and fear,” writes Ellis.
You can reduce investor risk by setting realistic investment goals, designing and sticking to a long-term strategy.
It’s the hard part of sticking to a long-term strategy and not being scared by short-term market fluctuations. Long term investors care about a future stream of income and dividends and how they grow or shrink. Short term traders don’t care about profits or dividends. They take care of investor psychology, which can fluctuate wildly from day to day and month to month.
You have to be there when lightning strikes. This is why market timing is a really bad idea. Don’t try
Author of “Winning the Loser’s Game”.
“Like the climate, the average long-term investment experience is never surprising. But like the weather, the short-term experience is often surprising,” writes Ellis.
To avoid getting sucked into something that you are uncomfortable with, Ellis recommends investors identify the intersection between their zone of competence and their zone of comfort.
Your competence zone is where you feel you have skills. You don’t want to choose stocks or funds or investment managers? Stick with index funds.
You feel calm and rational in your comfort zone. Uncomfortable with 90% of your money in stocks? Bring it to 60% or whatever level you are comfortable with.
The place where these spheres overlap is your investing sweet spot.
In a new chapter, Ellis notes that while bonds are a good diversifier and can help you feel less anxious, the fact that long-term bonds have a yield of less than 2% and inflation of 2% does so a very unattractive investment. “Not a good investment if you don’t get a real one [inflation-adjusted] returns, “warns Ellis.
Whatever you do, stick with it. “Do not go outside your zone of competence because you are making costly mistakes,” he writes. “And don’t get out of your comfort zone because you may get emotional and being emotional is never good for your investment.”
There aren’t many investing classics: this is one of them
In my 31 years covering markets for CNBC, I have read many investment books.
But over the years only a small group has made a lasting impact on my thinking and I keep turning to it.
“Winning the Loser’s Game” is one of them.
Others include “A Random Walk Down Wall Street” by Malkiel, “Common Sense on Mutual Funds” by Bogle (almost everything from the Vanguard founder is worth reading) and “Stocks for the Long Run” by Wharton Professor Jeremy Siegel.
To understand behavioral economics, I would add “Irrational Exuberance” by Robert Shiller and “Thinking Fast and Slow” by Daniel Kahneman. To understand why experts are so wrong in their forecasts and why the future is so difficult to figure out, Philip Tetlock describes “Expert Political Judgment: How Good Is It? How Can We Know?” as well as his follow-up book “Superforecasting: The Art and Science of Prediction”.
Read these books, understand their message, and you will have a solid foundation for a life of investing.