Charlie Ellis On Playing "The Loser's Game"

Charles D. Ellis, President of Greenwich Associates, wrote a seminal article entitled "The Loser's Game" in The Financial Analysts Journal for July/August 1975.

Ellis quickly offered a provocative and bold statement: "The investment management business is built upon a simple and basic belief: Professional managers can beat the market. That premise appears to be false."

He pointed out that over the prior decade, 85% of institutional investors had underperformed the return of the S&P 500 Index, largely because "money management has become a Loser's Game.…Institutional investors have become, and will continue to be, the dominant feature of their own environment … causing the transformation that took money management from a Winner's Game to a Loser's Game.

The ultimate outcome is determined by who can lose the fewest points, not who can win them." He went on to note that "gambling in a casino where the house takes 20% of every pot is obviously a Loser's Game."

Ellis went to the underlying economics of the matter: If equities provide an average return of 9% a year, and a manager generates 30% portfolio turnover at a cost of 3% of the principal value on both the sales and the reinvestment of the proceeds (a reduction in return equal to 1.8% of assets per year) and charges management and custody fees equal to 0.2% (low!), the active manager incurs costs of 2%. Therefore, he must achieve an annual return of +11% before these costs—that is, 22% above the market's return—just to equal the gross market return. (That 2% aggregate cost remains pretty much the same—although of a somewhat different composition—for mutual funds in 1997, 22 years later.)

While Ellis did not call for the formation of an index fund, he did ask: "Does the index necessarily lead to an entirely passive index portfolio?" He answered, "No, it doesn't necessarily lead in that direction. Not quite. But if you can't beat the market, you should certainly consider joining it. An index fund is one way."

In the real world, of course, few managers indeed have consistently been able to add more than those two percentage points of annual return necessary merely to match the index, and even those few have been exceptionally difficult to identify in advance.

Fortune: "Cost is the principal reason that investors are unable to outpace the market index"

In July 1975, in an article entitled "Some Kinds of Mutual Funds Make Sense," Fortune's Editor A.F. Ehrbar concluded some things that seem pretty obvious today: "While funds cannot consistently outperform the market, they can consistently underperform it by generating excessive research costs (i.e., management fees) and trading costs.…It is clear that prospective buyers of mutual funds should look over the costs before making any decisions."

He concluded that "funds actually do worse than the market." He had little hope that the mutual fund industry would rush to fill the gap created by the new view that cost is the principal reason that investors as a group are unable to outpace the market index.

But Ehrbar described the best alternative for mutual fund investors: "a no-load mutual fund with low expenses and management fees, about the same degree of risk as the market as a whole, and a policy of always being fully invested."

Ehrbar's conclusion holds true to this day.

Quotes from Charlie Munger

From the 2007 Wesco Financial Annual Meeting

• "Don't wrestle with a pig, you'll both get dirty but the pig will like it."
• "Charlie's favorite business analogy: the mouse who says 'let me out of the trap, I've decided I don't want the cheese."
• "You've earned your retirement."
• "To learn from a person, make then your friend - tie into their lives and personalities."
• "The first rule is don't fool yourself, and you're the easiest one to fool."
• "Always live below your financial means so you'll have money to invest."
• "Invest in such a way so that you'll never be in a negative position -avoid the use of debt."
• "Always seek the simplest most direct answer. Look at the problem backwards."
• "You guarantee failure when you learn everything from you own experience rather than learning from others."
• "To be a successful investor you need to understand your own psychology, if losing money makes you miserable, you should use a very conservative pattern of saving and investment."
• "To understand a business figure out what results it is achieving, why it is getting those results and what could happen to change what is causing those results. If everyone can understand this, then you'll have to pay a lot of money, so you'll have to determine if the price is worth it."
• "Americans are oversold on the benefit they receive from money managers and mutual funds. Save yourself a lot of time, money and worry and put your money into index funds."
• "Why should investors care if someone else is doing better or worse, when he rationally knows that in the long term his results will be superior by reason of lower costs and the long term effects of compounding."
• "In the process of not disappointing anyone, people must have the proper expectations and know what they are and are not getting."
• "Stick to basic principles and be alert for opportunity. There are not an unlimited number of opportunities."

Note: If you haven't attended a Wesco Financial Annual Meeting, I recommend you do so. They are held in the middle of May (a few days after the Berkshire Hathaway Annual Meeting) in Pasadena, CA.

Used Stock Salesman

In the recent USA TODAY/Gallup Poll

• measuring honesty and ethics among 23 occupations,
• only 17% rated stockbrokers "High" or "Very High"
• just behind lawyers (at 18%) and above U.S. Senators (at 15%).
  
  What investors need to know is that stockbrokers are:
  
  
• salespeople - selling you on activity;
• make their money on fees from the actions their clients' take;
• must put their employer's interests ahead of their clients' interests;
• only need to insure their clients are buying and selling "suitable" investments, not the investments that are in their best interests;
• are under no obligation to disclose conflicts of interest (i.e. making a commission on a mutual fund or how much commission they make on a bond transaction - although if you ask, they will give you the information).

Used Stock Salesman make money on your transactons whether you buy or sell, or make or lose money.

See the breaking news about a Long Island used stock salesman.