Charles Ellis’ investing classic explores why people are terrible day traders
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Do you think you are, or can be, a successful day trader, buying and selling stocks regularly?
Do you think that you, or someone you know, can successfully time the market, enter and exit the market, and consistently make profits?
You can’t, or at least not on a consistent basis over a reasonable period of time.
That’s the message of the new edition of Charles Ellis’ investing classic, “Winning the Loser’s Game”. First published in 1985, this eighth edition updates the central theses of the book: that passive investment (indexation) outperforms active investment, that investment costs are still too high, and that an understanding of behavioral economics is essential for understanding the way people invest and behave.
Unsurprisingly, Ellis says the evidence that index investing outperforms active investing is even stronger than in the latest edition, released in 2016.
If you think there are a lot of Warren Buffetts who can outperform the markets, you are wrong as well. Ellis’ fundamental question for the average investor is: “Can we find an investment manager capable of surpassing expert consensus enough to cover fees and costs and offset risks and uncertainties?”
The evidence is overwhelming. When adjusted for fees and risks, most investment professionals do not outperform and are not worth the time and money.
âActive investing is a loser’s game,â says Ellis.
The fact that most fund managers underperform their benchmarks is well known, but for those who don’t know how bad it is, Ellis reminds us all in Chapter 1: âOver a year, 70% of mutual funds underperform selected benchmarks; more than 10 years, it gets worse: almost 80% underperform. And 15 years later, even worse: the number is close to 90%.
Indexing has many other benefits: peace of mind, lower fees, lower taxes.
Are you tempted to try to time the market or the day trade? Ellis advises against this.
The timing of the market is not working. Most of the gains in the stock market occur over very short periods of time, and if you’re not there during those periods, you don’t get the gains. The problem is, no one knows when those days are coming.
Many studies point to the danger of not being in the market on a good day. Ellis cites a study using the S&P 500, where all of the 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 over those two decades.
The lesson is clear. âYou have to be there when the lightning strikes. That’s why market timing is a really bad idea. Don’t try,â Ellis writes.
Title selection does not work either. Not because the pickers are fools. Quite the contrary: “The problem is not that the investment research is not well done,” writes Ellis. “The problem is, the research is done so well by so many people … it is very difficult to gain and maintain a repetitive useful advantage over all the other investors on stock picking or price discovery.”
Princeton University professor Burton Malkiel, author of another investment classic, “A Random Walk Down Wall Street,” wrote an introduction to the 8th edition where he cited a study on day traders. Taiwanese conducted over a period of 15 years. Less than 1% was able to beat the returns of a low-cost indexed ETF, and over 80% lost money.
Why isn’t active investing working?
Ellis has never condemned the investment management community. He goes to great lengths to commend the industry for their dedication and hard work.
The problem, says Ellis, is not one of active deception but one of mathematics and probability. At least three issues work against the active trader:
- Institutional traders have become the market. There are so many dedicated professionals who have access to huge amounts of information and enormous computing power that it is difficult for a member of the group to outperform the markets over long periods of time.
- The fees and cost of trading make it almost impossible to outperform the market. This was one of the central ideas of Vanguard founder Jack Bogle. Talented active managers who have a modest edge do not outperform because the cost of trading and high fees erode any outperformance.
- The future is not like the past. Even if you can find an investment manager who has outperformed for a few years, they are unlikely to continue in this race. âManagers who have performed superior in the past are not particularly likely to perform superior in the future,â he writes.
The conclusion: “Active management costs more than it produces added value. No systematic study supports another view.”
How to win the loser’s game
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What should an average investor do? How to win at this loser’s game?
Don’t play. Have a good understanding of your own risk profile and largely stick with index funds that follow the market.
More important than understanding the market is understanding who you are. âIf you don’t know who you are, this is an expensive place to find,â Adam Smith wrote in âThe Money Gameâ.
Ellis’ key vision for investors is as follows: The winner is the one who makes the fewest mistakes. To make the fewest mistakes, focus a little less on returns and more on managing risk, especially the risk of serious permanent loss.
The key to investing risk is to remain 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: âOur demons and internal enemies are pride, fear, greed, exuberance. and anxiety, âEllis writes.
You can reduce investor risk by setting realistic investment goals, devising a long-term strategy and sticking to it.
Sticking to a long term strategy and not being afraid of short term fluctuations in the market is the hard part. Long-term investors care about a future stream of profits and dividends, and how they grow or shrink. Short-term traders don’t care about earnings or dividends; they care about the psychology of investors which can change enormously from day to day and month to month.
âLike the weather, the average long-term investment experience is never surprising. But like the weather, the short-term experience is often surprising, âwrites Ellis.
To avoid getting sucked into doing something that makes you uncomfortable, Ellis advises investors to determine the intersection between their area of ââexpertise and their comfort zone.
Your area of ââexpertise is the area in which you think you have expertise. Not comfortable choosing stocks or funds or investment managers? Stick with index funds.
Your comfort zone is where you feel calm and rational. Not comfortable with 90% of your money in stocks? Bring it to 60% or whatever level you’re comfortable with.
The place where these spheres overlap is your ideal point to invest.
In a new chapter, Ellis notes that while bonds are a good diversifier and can help you feel less anxious, the fact that long bonds pay less than 2% and inflation at 2% makes bonds an investment. very unattractive. “It’s not a good investment when you don’t get real [inflation-adjusted] is coming back, âEllis warns.
Whatever you do, stick to it. âDon’t go outside your area of ââexpertise because you will make costly mistakes,â he writes. “And don’t step out of your comfort zone because you can get emotional and being emotional is never good for your investment.”
There aren’t many investment classics: this is one of them
In my 31 years of covering the markets for CNBC, I have read a lot of books on investing.
But over the years, only a small group has had a lasting influence on my thinking and to which I turn again and again.
“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 anything written by the founder of Vanguard is worth reading) and “Stocks for the Long Run “from 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 wrong in their predictions and why the future is so difficult to understand, Philip Tetlock “Expert Political Judgment: How Good Is It? How Do We Know?” as well as his follow-up book âSuperforecasting: The Art and Science of Predictionâ.
Read these books, understand their message, and you will have a solid foundation for a lifetime of investing.