November 14, 2010

Winning the loser’s game - by Charles D. Ellis

Winning the loser’s game - by Charles D. Ellis

Timeless strategies for successful investing
[few of the recommended books on this topic - individual investing-, this is the best. The author highly recommends index funds and EFT funds are investment choice for individual investors]

The Loser’s game:

Contrary to investment manager’s often-articulated goal of out performing the market averages, the nation’s investment managers are not beating the market; the market is beating them. The basic assumption that most institutional investors can outperform the market is false. They cannot as a group, outperform themselves. In fact, given the cost of active management - fees, commission, market impact of big transactions and so forth, - 85% of investment managers have and will continue over the long term to under-perform the overall market.
That is why a large majority of mutual funds, pension funds and endowments are not successful; professional investing has become a loser’s game.
Individual investors 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)
In winner’s game, consider the profound difference between these two kinds of games. In winner’s game is the outcome is decided by correct actions of the winner. In loser’s game, the outcome is determined by mistakes made by the loser. (War is a loser’s game, flying flights is also a loser’s game).
The historical record shows that on a cumulative basis, over three-quarters of professionally managed mutual funds under-perform the S&P 500 stock market index.

Today’s money games include a formidable group of competitors. Several thousand institutional investors - hedge funds, mutual funds, pension funds and others - operate in the market. Even the smallest spends $100 million in typical year buying services from the leading brokers in New York, London, Hong-Kong, & Tokyo. Understandably these formidable competitors always get the ‘first call’ with important new information. This about the half the time that we individual investors buy and about half the time we sell, the ‘other fellow’ is one of those giant professionals with all their experience and all their information and all their analytical resources.

Investment professional usually buy or sell for reasons inside the stock market; however individual investors usually buy for reasons outside the stock market; they buy because they inherit money, get a bonus etc. and in the same way, they sell stocks when they have kids to go to school, or buy a new house etc. This way, they are making huge mistake. Most individual investors are not experts on even a few companies. Many gather information from newspaper, TV, friends, etc. The professional investors use the latest market feed like Reuters, Bloomberg and such sophisticated information services. they meet with corp. management frequently. They have teams of in-house analysts and senior portfolio managers with an average of 20 years of experience.

Beating the market:
The only way active investment managers can beat the market, after adjusting for market risk, is to discover and exploit other investors mistakes. In theory, active investment managers can try to succeed with any or all of four investment approaches.
1. Market timing
2. Selecting specific stocks or groups of stocks
3. Making timely changes in portfolio structure or strategy
4. Developing and implementing a superior, long-term investment concept or philosophy.
Market timing is very critical. In bond portfolio, the market timer hopes to shift into long maturities before falling interest rates drive up long-bond prices and back into short maturities before rising interest rates drive down long-bond prices. In a balanced portfolio, the market timer strives to invest more heavily in stocks when they will produce greater total returns than bonds, then shift into bonds when they will produce greater total returns than stocks, and then into short-term investments when they will produce greater total return than either bonds or stocks. Unfortunately more often any are tried, the ,more certainly they fail to work.
The historical statistics shows what happens to long-term compounded returns when the best days are removed from the record. Taking 10 best days - less than one-quarter of 1 % of long period examined - cuts the average rate of return by 17 %( from 18% to 5%). Taking the next 10 days away cuts returns by another 3 %. Removing a total of 30 days - just half of 1% of the total period - cuts return almost by 40% (from 18% to 11%).

Using S&P 500 average returns, the story is told quickly and clearly; all the total returns on the stocks in the last 75 years were achieved in the best 60 months - less than 7% of the 800 months of those long decades. If you missed those few and fabulous 60 months, you would have missed all the total returns accumulated over three generations. Removing five best days out of 72 years of investing would reduce cumulative compound returns - without dividend investments- by nearly 50%.
The second tactical way to increase returns is through ‘stock selection. Professional investors devote extraordinary skills. time and effort to this work. Stock validation dominates the research efforts of investing institutions and the research services of stockbrokers all over the world.

Strategic decision involves major commitments, which affect the overall structure of the portfolio. They are made to exploit insights into major industry groups, changes in the economy and interest rates or anticipated shifts in the valuation of major stocks.

Even after all these prep. things goes wrong. In a paper titled. ‘Why do investors trade too much’, it says, on average the stocks these investors bought from 1987 through 1993. These stocks were underperformed by 2.7% over the following year. while stocks they sold outperformed by 0.5% over the following year.
Experienced investors all understand four wonderfully powerful truths about investing and wise investors govern their investing by adhering to these four great truths.

1. The dominating reality is that the most important investment decision is your long-term mix of assets; how much in stocks, real estate, bonds or cash

2. That mix should be determined partly by the real purpose - growth, income, safety and so on - and mostly according to when the money will be used.

3. Diversify within each asset class and between asset classes. Bad things do happen - usually as surprises.

4. Be patient and persistent. Good things come in spurts - usually when least expected - and fidgety investors fare badly. ‘Plan your play and play your plan’ say the great coaches. ‘Stay the course’ is usually wise. So is setting the right course - which takes you back to #1.
The hardest work in investing is not intellectual; it is emotional. Being rational in an emotional environment is not easy, particularly with market always trying to trick you into making changes. the hardest work is not figuring out the optimal investment policy, it is sustaining a long term focus - particularly at market highs or market lows - and staying committed to your optimal investment policy.

The next step is to decide whether this loser’s game is ever worth playing. An index fund provides investment managers and their clients with easy alternatives. They do not have to play the more complex games of equity investing unless they want to. The freedom to invest at any time in an index fund is a marvelous freedom of choice because superior knowledge and skill are not consistent attributes of even the best investors. Given the intensity and skill of the competition, superior knowledge is rare.

The option to use an index fund enables any investor to keep pace with the market virtually without effort. Investors would be wise to devote attention to understanding the real advantage offered by the market index fund - the product of all the skill and work being done by every day by the investors dream team.

Here are some of the investor’s risks to avoid:
trying too hard
Not trying hard enough
Being impatient
Making mutual funds investment changes in less than 10 years (if you have mutual fund)
Borrowing too much
Being naively optimistic
Being proud
Being emotional
As the pundits says, ‘success is getting what you want’ and happiness is wanting what you get’ - you can be both successful and happy with your investments by concentrating on the asset mix and by living with and investing by a few simple truths so your investment really will work for and serve you and your purposes.

Here are the ‘unfair’ advantages of index investing in today’s market environment.
1. Higher rates of return because over the very long term 85% of active managers fall short of the market
2. Lower management fees (0.2%)
3. Lower operating expenses
4. Lower brokerage commissions
5. Lower market impact
6. Convenience
7. Lower taxes (fewer profits per year and hence less tax)
8. Freedom from error or blunder and peace of mind
9. Freedom to focus on really important decision like investment objectives and long-term polices & practices
10. Less anxiety or concern because you never have to worry that you might be making mistakes of omissions or commissions that will result in unusual losses or missed opportunities.

One alternative to index funds may be worth considering : ‘exchange traded funds (EFTs). Unlike mutual funds which are sold and redeemed by the fund company, EFT are made up of a bundle of stocks tracking a specific stock index trade on an exchange and can be bought or sold through brokers throughout the trading day.
(Vanguard & Morgan Stanley both offer the classic commodity S&P 500 index funds where vanguard charge 0.18% and Morgan charges 0.70%.)

As important as it is, deciding to index or use ETF is not just a final decision. Two more decision must be made. Which index or market and which particular index or ETF? For example, the S&P 500 had heavy weightings on several very large stocks that were selling at unsustainable high price, but when it got busted, it ended up in disappointing results that accurately matched the S&P 500.

In this situation, investors had three sensible choices.
1. Be patient - this too shall pass’ attitude
2. Invest in broader ‘total market’ index fund or
3. invest in index fund matched to a major area of stock market that was currently not popular such as low p/e ‘value’ stocks.

For most investors, the second option - total market index fund - is often most sensible choice, particularly if you have no reason to be selective in a particular way. If you decide to overweight small-cap stocks or emerging markets or even frontier markets in your portfolio, you can do so with index funds or EFTs or both. But aware: The argument for index funds is strongest when investing in the most efficient markets like those for large-cap stocks in US, UK and Japan. Specialized index funds and specialized ETFs invest in market that are not broad deep and efficiently priced. In smaller market, market replication is more difficult and less accurate.

Most investors are surprised to learn that the best plain vanilla index fund mix is half international. The reason, it is easy to see that investing proportionally in all world’s major stock markets and all the different economics those markets represent increases diversification significantly.

There are four factors that decide how & where to invest
1. Understanding each investor’s real needs
2. Defining realistic investment objectives to meet those realistic needs
3. Establishing the asset mix or portfolio structure best suited to meeting those risk and return objectives
4. Developing well-reasoned investment policies to implement the strategy and achieve the particular investor’s realistic long-term investment objectives.

Time transform investments from least attractive to most attractive and vice verse because while the average expected rate of return is not at all afflicted by time, the range or distribution of actual returns around the expected average is greatly affected.

The single most important dimension of your investment policy is the asset mix, particularly the ratio of fixed-income investment to equity investments. Analyses of asset mix show over and over again that the tradeoff between risk and reward is driven by one key factor: time.

The history of returns on investments as documented in study after study shows three basic characteristics:
1. Common stocks have average returns that are higher than those of bonds. Bonds in turn have higher returns than those of short-term market instruments.

2. The daily, monthly and yearly fluctuations in actual returns on common stocks exceed the fluctuations in returns on bonds which in turn exceed the fluctuations in returns on short-term money market instruments.

3. The magnitude of the period-to-period fluctuations in rate of return increases as the measurement period is shortened and decreases as the measurement period is lengthened. In other word, rate of return appear more normal over longer periods of time.

The winner’s game:
There are simple five levels of decision for each investor to make.
1. Settling on your long-term objectives and asset mix - the optimal proportion of equities, bonds and perhaps other assets to archive those objectives
2. Equity mix, the proportion in various types of stocks - growth versus value, large cap versus small cap, domestic versus international. If you have a large portfolio the same decision can be made on subcategories for each major asset class.
3. Active versus passive. For most investors, passive index funds will be the best long-term choice
4. Specific fund selection - deciding which mutual funds will manage each component of the overall portfolio
5. Active portfolio management - selecting specific securities and executing transactions.
One of the core concepts and basic themes of this book is that funds available for long-term investment will do best for the investor, if they are invested in stocks and kept in stocks for the long term.
The lower the price of shares when you buy, the more shares you will get for every $1000 you invest and the greater the amount of dollars you will receive in future dividends on your investments.

There are 10 commandments for individual investors
1. Save - invest your savings in your future happiness and security and education for your kids
2. Don’t speculate
3. Don’t do anything in investing primarily for tax reasons (tax shelters are poor investments)
4. Don’t think of your home as an investment.
5.Don’t do commodities
6. Don’t get confused about stockbrokers and mutual fund sales people
7. Don’t invest in new or interesting investments
8. Don’t invest in bonds just because you have hear that bonds are Conservative
9. Write out your long term goals and stay with them.
10. Distrust your feelings.

Estate Plan:
Do a proper estate plan for kids to inherit your wealth
1. Everyone who qualifies for an individual retirement account (IRA) should have one and contribute maximum every year, enabling the twin engines of long-term compounding and tax deferral to do their magic ($5000 is the maximum)
2. You can give up to $13,000 without tax to each person you wish every year (married couple can give $26,000)
3. You have a lifetime total limit of $1million on other tax free gifts to individuals
4. IRS allows you to put up $1million into generation-skipping tax-free family fund
5. A qualified personal residence trust enables you to transfer ownership of your house to your children and live in your home rent-free for a period of 15 years.

Estate lawyers will advise on more such topics.
Real Estate:
A remarkable proportion of the wealthiest individuals and families have made their fortune in real estate - Tax advantage are major factor; astute use of leverage and access to credit - lots of it - are important; extraordinary skill at adversarial negotiations is crucial; patience and deceive actions are both essential. In addition, success depends on extraordinarily intricate knowledge of all the relevant details of each local market and within a chosen market of each property, its tenants and their lease agreements, clever insights into ways of specific improvements will significantly enhance future rentals and a special ability to attract desirable tenants. An absolute devotion to the business is mandatory.

Books recommended:

The intelligent investor by Benjamin Graham
The Crowd by Gustave Le Bon
The only investment guide you will ever need by Andrew Tobias

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