Minimising Mistakes

Charley Ellis wrote a book many years ago called Winning the Loser’s Game, which explains why low-cost, buy-and-hold investment strategies are prudent for most investors.

Charley, now 86, recently joined a podcast with Cameron Passmore, whose firm PWL Capital in Montreal is a member of the Global Association of Independent Advisors with Lorica Partners.  You can listen to the podcast here: Rational Reminder, but below are six lessons Charley shared with investors.

Charley is a proponent of indexing.  Lorica Partners agrees indexing is valid in some asset classes, but there are also factors you can tilt a market portfolio towards to increase the long-term expected return.  The philosophy of both approaches remains the same – in public markets, the effort of trying to guess which stocks may outperform others will almost certainly cost you money rather than make you money.

1.      Success is all about minimising mistakes

“A loser’s game is any competitive activity, where the outcome is not controlled by the winner, but it’s controlled by the loser. Golf is a good example. People that are good at golf will shoot less than par, by two or three strokes on a regular basis. A lot of other people are proud to be able to shoot 90. There are some people who’ve never broken 100. Well, the difference between the two groups is the mistakes of the people who’ve never broken 100 and make all the time.

“Another loser’s game is tennis. If you look at your game, or at least my game, how many times do you win a stroke, instead of hitting it at the net, hitting it out of bounds, laying it up so easily for the other person hit it back, that you’ve essentially forced yourself into a loss? If you could cut back on the number of mistakes and let the other guy increase the number of mistakes he made, you’ll come out the winner of a loser’s game.

“That’s what investing is all about. Most of the activity we spend our time engaged in when investing doesn’t help. It actually does harm. Our long-term results are impoverished by the mistakes that we’ve made along the way.

“In investment management, if you could just reduce the number of mistakes you’ve made, you would come out as a winner. The easy summary of all that is, if you index, you won’t be making any mistakes. You have to choose the right index, that’s fair. If you index, you won’t be timing the market, you won’t be trading too much.”

2.      Active managers do more harm than good

“It’s gotten harder and harder and harder to be an active manager [meaning a manager who picks a concentrated portfolio of direct stocks they expect to outperform the market], and successful at the same time. More and more people have accepted indexing is a rational way of taking advantage of the realities of the market, rather than getting suckered into doing things that do you harm. I know you [the active fund manager] are wonderful. I know you’re terrifically talented. I know you work very, very hard. But you’re not helping yourself, or your clients.

“The perception is, you’ve got brilliantly talented people working hard for you all the time, that is true. The perception is they are going to be able to make a real difference to your economic situation. That’s very unlikely to be true. What is very, very likely to be true is you’re going to make a wonderful difference to their economic situation.” 

3.      Outperformance gets harder as aggregate skill increases

“Back in the 60s, there might have been as many as 5,000 people worldwide, involved in active investing. More than half of them would have been in the US. The next largest group would have been in the UK, and then sprinklings of people in Hong Kong or elsewhere, trying to figure out what they could do to get a comparative advantage.

“Well, today that 5,000 has been increased to something like 2 million - 2 million people does transform the nature of the market. Okay, so participants are really good. They also have terrific educations. You have MBAs all over the place today. That was a very rare thing years ago. You have PhDs, you have MDs. You have people who have all kinds of skills in there competing all the time. The intellectual level has been raised and raised and raised. Then you think, “Well, what kind of equipment do they have?” We had slide rules. What do you guys have?

“Well, we have more computing power in our pocket than an IBM 360… Everybody’s got a Bloomberg terminal. Everybody’s got Internet access. Everybody’s got terrific computing power. Everybody’s part of this fabulous worldwide network of information from all the major securities firms, with branches in all the major economies around the world, piling information into the system and making it available to everybody who wants to compete.” That is the system you are trying to consistently outperform to justify your high costs.

4.      Indexing is the rational choice for everyone (when investing in public markets)

“I don’t know of anyone I would say should not (index). I’ll give you a couple of examples. Most of us, who knew him, had the highest regard for David Swensen, who was the Chief Investment Officer for Yale and [whose career] turned into one of the truly outstanding records of achievement. It would be very hard to make an argument David Swensen should have been indexing. [When he started at Yale], he had most of the portfolio in index funds. Then gradually he found ways that active investing …that he was particularly good at…could provide an incremental return.

“Some of that was portfolio structure. He was not exactly the first, but one of the first to consider hedge funds. He’s one of the first to get involved in private equity. He was one of the first to get involved in venture capital. He was one of the first to get involved in creative real estate. David was a man who was extraordinarily bright, a rigorous thinker, and very disciplined in everything he did. He found that there were places he could get a competitive advantage structurally because parts of the market weren’t being all that well attended. A big change from then to today [as I’ve already discussed].

“Today, many other institutions are doing hedge funds and private equity and real estate and all kinds of other things like that. At the time, he was able to create quite a significant comparative advantage.

“The second thing, David was awfully good at selecting individual managers. He had over 100 different investment managers. If you looked at this list, I promise you, you would not have been able to say, “I know 20 names on this list.” Most people couldn’t come close. Most people would say, “I know two or three names, but the rest I’ve never actually heard of.”

“Candidly, you’ve got better things to do in terms of trying to figure out what kind of investing is best for your organisation, or for you as an individual? Defining the purpose of the investing is for most people where they could really do a lot of good for themselves.”

5.      Disciplined investing is like raising teenage children

“You got to recognise… all of us are always our own worst enemies. This is not because we’re mean-spirited people. It’s just that we’re human beings and we tend to make mistakes.

“How people feel is a very important part of the reality. It’s not how they feel today. It’s how will they feel when it doesn’t look like things are going the right way. That’s a little bit like the secret to raising teenage children, is to be able to take a long-term view, if you’re going to get upset about what they did, or didn’t do on a particular day, you’re not going to have an easy time being a parent. If you’re able to keep in mind, “No, no, no. By the time they’re 30, they’re going to be people I really like a lot,” you’ll be fine.

“I think the main thing (investors can do to manage their behaviour) is study the markets enough so you realise how skilful the price setting really is, and how hard it is for anybody to do better and instead say, “I’ll take what’s available.”

6.      The most important thing is to know yourself

“The most important thing any of us can do as individuals…is to figure out what is it about us that’s different? We differ a lot in terms of our age, our ability to save, how much we have saved, our attitude towards gifts to members of our family and inheritance. We differ in terms of our desires to accumulate for philanthropic purposes. We differ in terms of risk tolerance, or comfort. I mean, short-term risk tolerance and long-term risk tolerance, both. We differ substantially in how much we enjoy investing, and whether we’re interested in it or not. Are we willing to spend a lot of time trying to figure out what makes us tick? What’s our psychological weakness? What do we have to be protecting ourselves against? All sorts of things like that.

“We are all unique. If we just have a little bit of reverence and appreciation for the fact that we’re all different, and then find out what’s right for us and stay focused on what’s right for us, I think we’ll be very, very well advanced.

“I’m an art history major, but I had friends who were engineers. They all told me the same thing. Most of engineering is learning how to figure out and define the problem. Solving the problem is not very hard. Most of us candidly, with regard to investing, have not figured out what is the problem. [Which is our own behaviour]”

Author Rick Walker

Source: this article was used in creating the Lorica Partners article: Charley Ellis: six nuggets of investment wisdom | TEBI (evidenceinvestor.com)