Praise for the new edition of Winning the Loser’s Game “The best book about investing? The answer is simple: Winning the Loser’s Game.” —F William McNabb III, Chairman, President, and CEO, The Vanguard Group, Inc “A must-read classic that has stood the test of time—both in the markets and on the courts.” —Martin Leibowitz, Managing Director at Morgan Stanley Research “This remarkably insightful and lucidly written investment classic should be required reading for every serious investor.” —Burton G Malkiel, author of A Random Walk Down Wall Street “The first edition of Charley Ellis’s great Winning the Loser’s Game was published in 1985 Each subsequent edition has gotten more comprehensive, and more timely, and his seventh edition is best of all Read it Enjoy it Learn from it.” —John C Bogle, Founder of the Vanguard Group and First Index Mutual Fund “This is by far the best book on investment policy and management.” —Peter Drucker “As a rookie reporter in the 1980s, I read a slim book with an unassuming title: Investment Policy It’s simple but powerful message changed the way I thought about investing Today, Investment Policy is called Winning the Loser’s Game It’s considered an investment classic, and deservedly so For those who have never enjoyed the wisdom of Charley Ellis, a treat awaits you.” —Jonathan Clements, author of How to Think About Money and founder of HumbleDollar.com “A must-read This clearly written book explores concepts essential to both institutional and individual investors It is not a simplistic ‘do-it-yourself ’ cookbook, but an elegant guide to investment truths and paradoxes.” —Abby Joseph Cohen, Stock Market Strategist and Managing Director, Goldman, Sachs & Co “Radical in its simplicity Investors—institutional and otherwise—will find this jolt to their cherished beliefs refreshing.” —Adam Smith, author of Adam Smith’s Money World “An outstanding guide for the individual investor, full of sound and useful advice for making one’s way through the confusing maze of our contemporary financial world.” —William E Simon, former Secretary of the Treasury “No one understands what it takes to be a successful investor better than Charley Ellis and no one explains it more clearly or eloquently This updated investment classic belongs on every investor’s bookshelf —Consuelo Mack, Executive Producer and Managing Editor, Consuelo Mack WealthTrack “This is less a book about competition than about sound money management Sounder than Charley Ellis they not come.” —Andrew Tobias, author of The Only Investment Guide You’ll Ever Need “Ellis has written a liberating book about investing This book will enable you to face your money matters squarely, with intelligence and vision, and help you create a plan that will increase the security and freedom of your later years” —Byron R Wien, Morgan Stanley Copyright © 2017 by Charles D Ellis All rights reserved Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher ISBN: 978-1-25-983805-7 MHID: 1-25-983805-6 The material in this eBook also appears in the print version of this title: ISBN: 978-1-25-983804-0, MHID: 1-25-983804-8 eBook conversion by codeMantra Version 1.0 All trademarks are trademarks of their respective owners Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark Where such designations appear in this book, they have been printed with initial caps McGraw-Hill Education eBooks are available at special quantity discounts to use as premiums and sales promotions or for use in corporate training programs To contact a representative, please visit the Contact Us page at www.mhprofessional.com This publication is designed to provide accurate and authoritative information in regard to the subject 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own noncommercial and personal use; any other use of the work is strictly prohibited Your right to use the work may be terminated if you fail to comply with these terms THE WORK IS PROVIDED “AS IS.” McGRAW-HILL EDUCATION AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE McGraw-Hill Education and its licensors not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free Neither McGraw-Hill Education nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom McGraw-Hill Education has no responsibility for the content of any information accessed through the work Under no circumstances shall McGraw-Hill Education and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise For Linda Lorimer, my beloved wife and best friend You helped me learn that striving to maximize quantitative investment results was not as important as assuring financial security and the freedom to enjoy living well comfortably CONTENTS PREFACE INTRODUCTION THE LOSER’S GAME THE WINNER’S GAME BEATING THE MARKET MR MARKET AND MR VALUE THE INVESTOR’S DREAM TEAM INVESTOR RISK AND BEHAVIORAL ECONOMICS YOUR “UNFAIR” COMPETITIVE ADVANTAGE INDEXING THE PARADOX TIME 10 RETURNS 11 INVESTMENT RISKS 12 BUILDING PORTFOLIOS 13 WHOLE-PICTURE FINANCE 14 WHY POLICY MATTERS 15 PLAYING TO WIN 16 CHALLENGES WITH PERFORMANCE MEASUREMENT 17 THE DARK MATTER OF INVESTING 18 PREDICTING THE MARKET—ROUGHLY 19 INDIVIDUAL INVESTORS 20 SELECTING MUTUAL FUNDS 21 PHOOEY ON PHEES 22 PLANNING YOUR PLAY 23 DISASTER AGAIN & AGAIN 24 GETTING RIGHT ON 401(K) PLANS 25 ENDGAME 26 THOUGHTS FOR THE WEALTHY 27 YOU ARE NOW GOOD TO GO! 28 PARTING THOUGHTS APPENDIX A: SERVING ON INVESTMENT COMMITTEES APPENDIX B: MURDER ON THE ORIENT EXPRESS APPENDIX C: RECOMMENDED READING INDEX PREFACE Lucky me! Married to a wonderful and inspiring woman, I was born in the United States; privileged in education; blessed with parents, children, and grandchildren I like, admire, and enjoy; and also blessed with an unusually wide global circle of friends in investment management—an endlessly fascinating profession in a remarkably favored business—replete with bright, engaged, and creative people Investing can seem way too complex, and investing wisely can take too much time Most individuals are too busy to take the time to “learn all about it.” They and you have better things to With increasing concern, I’ve seen the long-term professionalism that attracted me to investing get increasingly compromised by short-term commercialism and investor uncertainties about how to manage investment for the long term With all my advantages comes a clear responsibility to serve others That’s why I wrote this book Over the past century, the securities markets have changed massively, and in many ways, creating an overwhelming problem for individual and professional investors Those profound changes are explained in Chapter 1, “The Loser’s Game.” Raised in a tradition that if you recognize a problem, you should look for a good solution, I’ve written this short book of straight talk Each reader can understand the realities he or she faces and know how to take appropriate action to convert the usual loser’s game into a winners’ game in which every sensible investor can and should be a long-term winner As Winston Churchill so wisely observed, “People like winning very much!” We all like winning with investments, and we all can win—at lower costs, less risk, and less time and effort if we can clarify our real objectives, develop sensible long-term policies, and stick with them so the markets’ fluctuations are working for us, not against us In over 50 years of learning about investing from outstanding practitioners and expert theorists around the world, I’ve tried to collect, distill, and explain clearly and as plainly as possible the principles for successful investing For both individual investors and institutional investors who have the necessary self-discipline and wish to avoid the loser’s game, the simple messages in this short book are now and will be the keys to success in the winner’s game of sensible investing for the next 50 years The core principles of successful investing never change—and never will Sure, the companies change, and markets and economies go up and down—sometimes a lot In fact, when short-term data appear to be most challenging to core principles is exactly when they are most important and most needed That’s why, when you’ve read this book, you’ll know all you really need to know to be successful in investing Many people—too many to name—have generously contributed to my long learning about investing Ruth Hamel’s deft editing has improved every page She is a joy to work with and learn from Brooke Rosati, patiently smiling and humming as we work together in our small office, has converted my hieroglyphics into consistent clear copy Charles D Ellis New Haven, CT Labor Department, U.S., 184 Lakonishok, Josef, 35 Large cap stocks, 50 The Law and the Lore of Endowment Funds (Carey and Bright), 82 Legal restrictions, 81, 82 Leverage, 204–205 Life cycle funds, 214 Liquidity, 127 Little, Ian M D., 141 Long-term interest rates, 92 Loser’s game: active investing as, 13–14 flying as, golf as, 4–5 investment as, 3, 5–8 professionals playing, 7–8 tennis as, 3–4 ultimate irony of, 126 war as, winner’s game’s differences with, 3–6 winning, 238, 239 Losses: anxiety over, 121 avoiding, 112 destructiveness of, 60–61, 112 Madoff, Bernie, 201–202, 204 Malkiel, Burt, 175 Market averages: individual investors beaten by, 36 individual investors beating, 81 investment managers beating, 1–3, 77, 140 mutual funds beating, 6, 131 professionals beaten by, 36 Market efficiency, 55 Market history, 41–42 Market impact, 72 Market recovery, 24, 107 MarketRiders, 20 Market risk: definition of, 101 inflation risk’s trade-off with, 186–187 as investment management primary objective, 106 in investment policy, 106 investment strategy influenced by, 52 investors’ optimal level of, 52, 104–105 magnification of, 110–111 managing, 106 opportunity cost of avoiding, 80 Markets: active managers outperforming, 7, 13, 23–36 active managers underperforming, 72 anxiety caused by drops in, 121 beating, 239 as efficient, 13–14, 28, 32–34, 47–48 emotionally difficult way to beat, 70 index funds underperforming, 50 institutional investors operating in, institutional investors outperforming, 2–3 intellectually difficult way to beat, 70 investment managers underperforming, 2–3, 136–137 investment program choice influenced by, 41 investor behavior influenced by, 119–121 investors adapting to, 189 investors averaging, 98 investors influenced by, 200 investors keeping pace with, 49 investors working with, 52 mutual funds underperforming, 140 physically difficult way to beat, 70 professionals influencing, 28 role of, 59 study of, 122 subprime mortgages slamming, 153–154 transformation of, 13–14 two tier, 29 Market timers, 25 Market timing: active investing by, 24–27 costs of, 24 difficulties of, 25 returns from, 25–27 returns increased by, 24–27 spending determined by, 195 taxes in, 24 Marx, Groucho, 234 Maslow, Abraham, 225 Maturity premium, 95 Mean reversion, 92 Mitty, Walter, 35, 45 Money: emotional power and symbolism of, 157–158 investors represented by, 157–158 symbolic meaning of, 218 Money market funds, 214 The Money Masters (Train), 169 Morgan, J P., 151 Morgan Bank, 180 Morison, Samuel Eliot, Morningstar, 50, 135, 148 Mr Market, 39–43 emotions influenced by, 64–65 investors ignoring, 65 self-understanding as shield against, 120 Mr Value, 39–43 Municipal bonds, 199–200 Murder on the Orient Express (Christie), 257 Mutual fund families, 174 Mutual fund investors, returns received by, 137–138 Mutual fund managers: breach of fiduciary responsibility by, ix–x selecting, 174–175 underperformance of, 258–259 Mutual fund ratings, 135 Mutual funds: changing, 64, 173–174 deletion of failures from statistics on, 145–146 failure to meet own benchmarks, 147 fees, 173, 174, 183 as long term, 64 market averages beaten by, 6, 131 market underperformed by, 140 performance of, 136–140, 144–148, 175 returns on, 57–58 selecting, 171–176 survivorship and style consistency of, 148 underperformance of, 1–2 Neff, John, 176 Negative-sum game, Nest-egg goal, 191 New firm bias (See Backdating) News, 62 New York Stock Exchange (NYSE): institutional investors’ trades on, 34 investors in, 14, 159 professionals using, 159 trading volume, 14 Nifty 50, 29 Noise, 158 Northern Trust, 215 NYSE (See New York Stock Exchange) Odean, Terry, 20, 34–35 Oil stocks, 29 Onassis, Jackie, 220–221 Opportunity costs, 80, 161, 197 Ownership costs, 193–194 Panics, 122 Passive management, 50 Pasteur, Louis, 98 Pension funds: as fringe benefits, 179 investment managers of, 20 P/E ratio (See Price/earnings ratio) Performance: active investors pursuing, 36 of active managers, predicting, 16, 20, 51 dispersion in, 139 events wiping out, 42 expectation signaling, 139 fees eroding, 215 as gross of fees, 20 of individual investors, 34 investors surprised by, 41–42 of mutual funds, 136–140, 175 past performance predicting future, 172, 260 portfolio turnover influencing, 138 random walk described by, 96 risk mentioned in, 15 size as enemy of, ix–x taxes adjusted for by, 15 time influencing, 138 Performance measurement, 247 challenges with, 129–141 factors separated in, 133 of investment managers, 248–252, 261–263 investment policy distracted from by, 140 investors frustrated with, 139–140 professionals frustrated with, 139–140 skill determined by, 134 statistics reported by, 131 usefulness of, 131, 139 Pharmaceutical stocks, 29 Philanthropy, 224–227 Pilots, 41, 42 Plexus Consulting Group, 35 Pogo (comic strip character), 59 Poirot, Hercule, 257 Ponzi, Charles, 202 Ponzi scheme, 201–202 Portfolio management: as engineering, 109–110 investment policy separated from, 246–247 investment research influencing, 15 strategic decisions in, 28 Portfolio managers: institutional portfolios influencing, 20 Nifty 50 invested in by, 29 Portfolios: design, 110 investment strategy as foundation for, 79 relative-to-market outcome of, 120 reserves influencing, 127 time influencing, 83 Portfolio turnover: performance influenced by, 138 taxes influenced by, 75 Power, 218 Prediction market: professionals creating, 181 stock market as, 46 Present value, 91 Price discovery, 12, 27–28, 33, 60, 132, 180 Price/earnings (P/E) ratio, 151–152 Price risk, 102 Prices: active investors changing, 89–90 dividends influencing, 169 in efficient markets, 32–34, 48 future earnings influencing, 169 institutional investors setting, 23, 28 present values influencing, 91 professionals finding, 90 random walk of, 48 returns and, 42 of stocks, 89–90 Principal interests, agency interests vs., 264 Principle of indeterminacy, 140 Private equity funds, 235 Professionals: amateurs losing to, 8, 34–35, 158–159 amateurs vs., 3–4 basic responsibility of, 112 consensus determined by, 89–90 errors created by, 13–19 indexing for expertise of, 46 investment counseling done by, 12–13 investment opportunities found by, 89–90 investments changed by, 71 on investor’s dream team, 45–46 investors guided by, 19 loser’s game played by, 7–8 market averages beating, 36 market influenced by, 28 mission of, 13–14 mistakes made by, NYSE used by, 159 other professionals outperforming, 7–8 performance measurement frustrations of, 139–140 prediction market created by, 181 prices found by, 90 professionals outperforming, 47 stock selection used by, 27–29 Profits: asset gathering increasing, x, 17–18 investment business focusing on, 17 investment management’s increases in, 17 Vanguard’s philosophy and, x–xi Purchasing power, 160, 187–189 Pursuit of happiness, 218 Qualified personal residence trust, 220 Ramo, Simon, 3–4 Random walk: performance describing, 96 of prices, 48 A Random Walk Down Wall Street (Malkiel), ix Rates of return: on common stocks, 85–87 components of, 93–95 compound interest and, 96–97 differences in, 96–97 estimating, 198 extra, 110 income requirements influencing, 127–128 on indexing, 72 regression to mean, 93 time influencing, 93 time period used to calculate, 84 on Treasury bills, 94 Rationality: behavioral economists on, 61–63 as investing key, 157–158 of investors, 61–63 Real estate, 234–235 Real estate investment trusts (REITs), 235 Reg FD (See Regulation Fair Disclosure) Regression to mean, 130 investment managers and, 132 of returns, 134–135 Regulation Fair Disclosure (Reg FD), 14, 28, 181–182 Reinvestment: bond, 199 dividend, 164 REITs (See Real estate investment trusts) Relative-to-market outcome, 120 Research analysts, 28 Research firms, 57 Reserves: portfolio influenced by, 127 saving accumulating, 161 Retirement, 194–199 (See also 401(k) plans; Pension funds) age of, 208, 210–212 old age vs., 190 spending limits during, 194, 195 Returns, 89–99 base rate of, 97 benchmark, 247 on bonds, 92, 94–95, 199–200 characteristics of, 92 on common stocks, 85, 92, 94, 95 components of, 105–106 consistency of, 95 fees as percentage of, 178 fluctuations in, 93 forms of, 89 inflation influencing, 96 of investment managers, 259–260 investment managers focusing on, 60 investment policies needing, 96 investors expecting, 151 investors focusing on, 60 investors influencing, 65 magnification of, 110–111 from market timing, 25–27 market timing increasing, 24–27 of mutual fund investors, 137–138 on mutual funds, 57–58 prices and, 42 regression to mean of, 134–135 risk driving, 106, 108 on short-term money market instruments, 92 on S&P 500, 26–27 of stock market, 152 stocks producing, 186–187 study improving, 122 taxes hurting, 75 time influencing, 87 Treasury bills producing, 186–187 turnover hurting, 75 Righting arm, 92 The Right Stuff (Wolfe), 42 Risk: active investors’ views on, 102 in bond portfolio management, 111–112 characteristics of perceptions of, 121 definition of, 101 discount rate influenced by, 91 diversification reducing, 104, 105 divisions of, 107 index funds avoiding, 104–105 in investing, 60–61, 80 investing categories of, 52 long-term, 107 performance mentioning, 15 real, 102 reducing, 65 returns driven by, 106, 108 short-term, 107 for stocks, 106–108 types of, 102–103 as uncertainty, 101 Risk tolerance: definition of, 107 determining, 172 investor behavior anticipated by, 107 Rosenberg, Barr, 130 Rosenberg, Claude N., 227 Roth individual retirement accounts (Roth IRAs), 215 Rule of 72, 162, 169 Sailing, 19–20, 52, 92 Sampling error, 133 Santayana, George, 122 Saving: automatic, 190, 214 debt reduced by, 190 determining, 196 as priority, 161 underspending as key to, 190 Securities and Exchange Commission (SEC), 6, 202 Security analysis, 28 Security Analysis (Graham and Dodd), 154 Self-understanding: investors’ need of, 18 as Mr Market shield, 120 Shakespeare, William, 199, 265 Shareholder rights, 169 Sharpe ratios, 247 Shiller, Robert, 154 Shleifer, Andrei, 35 Short-term money market instruments, 92 Skiing, 19, 78 Skill, 134 Small-cap stocks, 134 Social Security, 117, 200, 211–212 S&P 500 (See Standard & Poor’s 500) Speculating, 165 Speculative return, 152 Spending: investment programs influenced by, 194 market timing determining, 195 rules, 194 Split-strike conversion, 201 Stable value funds, 214 Standard & Poor’s 500 (S&P 500): index funds, 76 recovery of, 107 returns, 26–27 State Street, 215 Statistics: individual investors learning about, 93 performance measurement reporting, 131 starting point of, 133 Stein, Gertrude, 135 Stockbrokerage commissions, 171 Stockbrokers, 171 Stock exchanges, 181 Stock-group risk: definition of, 103 eliminating, 103–104 Stock market: challenge in, 43 individual investors influenced by, 158 predicting, 151–155 as prediction market, 46 return of, 152 Stock portfolios, 28 Stock(s): cost of trading, 35 elderly investors investing in, 162 emotion influenced by, 64–65 investment in, 162 investors’ preferences in, 162–164 price of, 89–90 returns produced by, 186–187 risk for, 106–108 taxes on, 199 Treasury bills compared with, 186–187 Stock selection, 27–29 Stock trades, 34–35 Strategists, 69–70 Strategy: of active manager, for index funds, 73 investors maintaining, 186 Strategy and Compromise (Morison), The Structure of Scientific Revolutions (Kuhn), 53 Study: of investment history, 122 investments protected by, 237–238 of markets, 122 returns improved by, 122 Subprime mortgages, 111, 153–154 Sufficiency of income, 189 Sullenberger, Chesley “Sully,” 57 Sultan, 186 Summer rally, 36 Super quants, 57 Survivorship bias, 21, 132–133 Target data funds, 214 Tax-deferred investing, taxable investing vs., 213 Taxes: active managers generating obligations of, 157 estate, 221, 222 gifts and, 219–221 index fund, 51, 72, 137 investment programs influenced by, 193 in market timing, 24 performance adjusting for, 15 portfolio turnover influencing, 75 returns hurt by, 75 on stocks, 199 Tax-free municipal bonds, 199–200 Tax shelters, 166 Technology, 119–120 Technology stocks, 29 10 commandments of investing, 166–168 Tennis, 3–4 Time, 83–87 asset mix influenced by, 87 dividends’ importance influenced by, 92 investment choices influenced by, 83–84 investment objectives influenced by, 127 investment programs influenced by, 83 performance influenced by, 138 portfolios changed by, 83 in rates of return calculations, 84 rates of return influenced by, 93 returns influenced by, 87 Tracking error, 50 Trading volume, 14 Train, John, 169 Transaction costs, 10, 251 Transcendences, 225 Treasury bills: rate of return on, 94 returns produced by, 186–187 stocks compared with, 186–187 True fees, 260 Trust and estate lawyers, 183–184, 230 Turnover, returns hurt by, 75 Twain, Mark, 36–37 2008 financial crisis, 204–206 Two tier market, 29 UK (See United Kingdom) Uncertainty, 101 Underspending, 161, 190 Unfair competitive advantage: strategists seeking, 69–70 through index funds, 70–73 United Kingdom (UK), 20 United States (U.S.), 20 Value, price and, 33 Vanguard, x–xi, 215 Venture capital, 232–234 Viking Raiders, 202, 203 Viscosity of acceptance, 54 Vishny, Robert, 35 Vizier, 186 Vonnegut, Kurt, 223 War, Wealth, 218 Wealthy and Wise (Rosenberg, C.), 227 West, Mae, 218 When Harry Met Sally (film), 231 Whole-picture portfolio, 116–117 “Why Do Investors Trade Too Much?” (Odean), 34–35 Wills, 224–225 Winner’s game: investing as, 243 loser’s game’s differences with, 3–6 Wolfe, Tom, 42 Yale University, xi–xii, 230 Zone of competence, 66 Zone of confidence, 66 Zweig, Jason, 121 ABOUT THE AUTHOR Charles D Ellis founded and served for three decades as managing partner of Greenwich Associates, the global leader in strategy consulting to professional financial service firms There he consulted with the world’s leading investment managers and securities firms in North America, Asia, and Europe The author of 17 books and well over 100 articles on investing and finance, Ellis has taught advanced investment courses at both Harvard Business School and the Yale School of Management His path-breaking paper “The Loser’s Game,” published in the Financial Analysts Journal, won the profession’s Graham and Dodd Award for excellence in 1975 In addition to chairing CFA Institute, the investment management profession’s worldwide association, and being one of only a dozen leaders honored for lifetime contributions to the investment profession, Ellis has served as a trustee of Phillips Exeter Academy, an overseer of the Stern School of Business at New York University, a trustee and chair of the finance committee of the Robert Wood Johnson Foundation, a director of Vanguard, and successor trustee and, for many years, chair of the investment committee of Yale University He is chairman of the Whitehead Institute for Biomedical Research In recent years, Ellis has served as an advisor to large institutional funds and investors in Australia, New Zealand, Singapore, Vietnam, Saudi Arabia, the United Kingdom, Qatar, Canada, and the United States His most recent book, The Index Revolution, also published by John Wiley & Sons, explains how major changes in investment management and securities markets over five decades have inevitably made indexing increasingly compelling for all investors ...Praise for the new edition of Winning the Loser’s Game The best book about investing? The answer is simple: Winning the Loser’s Game.” —F William McNabb III, Chairman, President, and CEO, The Vanguard... the losers underperform the market one and one-half times as much as the “winners” outperform Nor the data adjust for taxes, particularly the high taxes on short-term gains that come with the. .. now and will be the keys to success in the winner’s game of sensible investing for the next 50 years The core principles of successful investing never change—and never will Sure, the companies