The secret to winning the “game” of investing over the long term is to determine each investor's unique objectives and then figure out the policies that will have the best prospects of achieving that particular investor's goals over the long run.
The right investment program for any particular person can look very wrong unless the individual's utility values are understood. Here's a personal example that looks wrong.
My grandparents left $10,000 to each of their grandchildren in 1946. While the post-war economy boomed and the stock market rose strongly over the next 15 years, these funds were kept in a bank checking account. Even with 20/20 hindsight, I believe that was the right “investment” policy—for those directly involved. Here's why:
My mother knew what she was doing and why. Her father was a country lawyer in Mississippi who went broke during the Depression like every other lawyer in the Delta region. So, to stay at Northwestern University, my mother borrowed tuition from Kappa Alpha Theta, her fraternity (the term “sorority” was not yet used), and then spent the next 15 years typing students' papers at 8¢ a page and sewing little girls' dresses at $1 per dress to repay those loans.
Mom knew how important it was to have enough for college in the bank. She was determined her children could go to first-rate colleges, so she wanted to be sure we had enough of our own money to cover whatever we couldn't get in scholarships. She believed our small inheritances would be enough to cover what we might need. To risk that assurance and maybe not achieve the “dream” of a college education just to get more than we needed made no sense at all to my mother.
Why, you might ask, not at least put the money into a savings account? Mom had personally experienced the bank holidays of the 1930s and she had read the fine print: Our local savings banks reserved the right to wait 30 days before paying out a withdrawal. And Mom knew that banks could fail in a lot less than 30 days. So our college savings were kept for 15 years in a checking account—so they could be withdrawn immediately if the bank looked shaky.
All things considered, would anyone think my mother's investment policy wrong? Not I. She understood the game and knew how to win—and all four of her children went to fine colleges.
Generically, a loser's game is any game, contest, or activity in which the ultimate victor is determined by the actions of the loser. These contests are not won; they are lost. Amateur tennis is a classic loser's game because most points and most matches are not won. They are lost. You keep hitting balls back to me, but I double-fault or hit shots out or into the net until the set is over, and you are the winner. But you didn't determine the outcome by playing better; I produced the outcome—by playing worse.
In a winner's game, the winner not only wins, but also causes his or her victory as we see when watching the Williams sisters at tennis or Tiger Woods at golf. The encouraging reality is that every investor can be a winner of the winner's game of investing because there is no adversary who must lose in order for you to win. And the requirements for winning are all quite understandable:
Most investors will benefit from the self-disciplining exercise of committing to writing their explicit definitions of all three parts of the winning triangle:
The challenge to the investment profession is becoming increasingly clear. The centerpiece of every long-term investment program is the most underdeveloped level of the game—Level One: Setting the policy normal asset mix.
Part of the benefit of a written investment program is the discipline this gives to our efforts to be rational and rigorous. Part of the benefit comes when we invite serious friends to review and critique our articulation and to offer any challenges they consider significant. And part of the benefit comes from carefully reviewing the written document regularly, typically once each year, to be sure it is as understanding as possible of ourselves and the markets.
While most investors take investment services as a blended package, it is important to unbundle the package into separate levels of the game. In making investment decisions, there are five separate levels of decisions for each investor to make individually:
Investors should recognize that investing is not necessarily a single, bundled package, but can be divided into separate levels and investors can engage in or ignore each level. And investors are free to choose. This freedom of choice is truly splendid because investors can avoid losing the loser's game on Levels Four and Five, and can concentrate on winning the winner's game on Levels One and Two.
As human beings, particularly if we are successful in other parts of our lives, we are notoriously unable to accept the obvious reality that, on average, we are average, and that our normal experiences will usually be “about average” because we are, as a group, captives of the normal distribution of the bell curve. It amuses us that Lake Wobegon's children are all above average, yet studies show we think we are above-average drivers, above-average parents—and above-average investors. And we do tend to take it personally when our stocks go way up or go way down, even though, as ‘Adam Smith’ admonished, “The stock doesn't know you own it.”
Every investor should recognize the powerful potential impact of luck—not only good luck, but also, bad luck. We can all live through good luck. But bad luck, the apparently random occurrence of adversity, is equally prevalent and its consequences can be far greater.
Knowing that the levels of the game are separable liberates the investor (or the investor's investment manager) to decide whether to be active at each separate level. At least implicitly, the freedom of choice presents a responsibility to choose, because not to decide is to decide. Yet the secret to success, as experience demonstrates again and again, is not playing the loser's game on Levels Four and Five, but instead concentrating on the winner's game on Levels One and Two.
Experienced investors know that the high-to-low order of cost is the mirror opposite of the order of value:
Tommy Armour, the great teaching professional in golf, focused on two key propositions:
The sad irony in the investment profession is that most practitioners and most clients devote most of their efforts to Level Five and incur most of their costs competing against a virtually unbeatable array of contending forces: the institutional investors who are too many, too well informed, too talented, too quick to react, too intensely striving to win ever to be beaten over any long period by anything like enough of a margin to cover the costs of playing the game on Level Five.
And the record on Level Four is also quite discouraging. While institutions, with all their expensive advisors and consultants, may experience somewhat less harm by changing investment managers, the poor record for individual investors in mutual funds is unsettling.
The long-term passage through the terra incognita of future markets is sure to be accompanied by the uncertainties and disruptive challenges of that wily, disconcerting companion we cannot shake: Mr. Market. Emotionally unstable, Mr. Market veers from years of euphoria when he can see only the favorable possibilities of industries, companies, and their stocks to profound pessimism when he's so depressed he can see nothing but trouble ahead.
Mr. Market persistently teases investors with gimmicks such as surprising earnings, startling dividend announcements, sudden surges of inflation, inspiring presidential pronouncements, grim reports of commodity prices, announcements of amazing new technologies, distressing bankruptcies, and even threats of war. These events come from his bag of tricks when they are least expected. Just as magicians use deception to divert our attention, Mr. Market's very short-term distractions can confuse our thinking about investments.
Mr. Market dances before us without a care in the world. And why not? He has no responsibilities at all. As an economic gigolo, he has only one objective: to be attractive. Mr. Market constantly tries to get us to do something—anything, but at least something—and the more activity, the better. Explorers, pilots of single-engine planes, and ocean sailors all know that while adventure and achievement are what laypeople think about, the experienced practitioner's thoughts and actions are centered on the disciplines of defense—not running out of water, not running short of food, not getting lost, not getting frightened—because they know from experience that the essential foundation for a successful offense is a strong defense.
The best defense against Mr. Market's seductive tricks is to study stock market history—just as airline pilots spend hours and hours in flight simulators, practicing flying through dreadful storms, landing at unfamiliar airports, and dealing with mechanical malfunctions so they are well prepared to remain calm and rational when faced with such situations in real life. (They also learn that surprises are not surprising: They are actuarial expectations on a bell curve.)
As more and more individuals become responsible for the investment policy of their retirement assets, particularly via 401(k) plans, it is even more necessary to develop realistic long-term goals and policies that effectively integrate three realities.
The Reality of Current Resources and Probable Additions. We need to know the present value of likely additions to a portfolio (through savings or inheritance) that should be included in our present thinking.
The Reality of the Market's Most Likely Behavior. We need to recognize the market's behavior during and over the period of investment. Two assumptions are reasonable and easy to use:
Most investors overemphasize the favorable possibilities, striving to maximize returns with a hold offense. These investors would benefit from giving more attention to their defenses, and to not losing. That's why:
All investors will experience uncomfortable fluctuations in the market. That's reality—and fluctuations should not be a major concern. The real concern is with irreversible losses caused by overreaching for speculative possibilities; by taking market risks greater than our capacity to endure major turbulence and maintain consistent rationality; by reaching for managers whose best performance is likely behind them and who are destined to underperform with your money; and by going into debt.
The Reality of Future Objectives for Spending from Invested Funds. Most individual investors have some room for maneuvering and can adapt some of their future objectives to the changing realities of financial capacity, so it is often informative to categorize goals and objectives by degree of importance.
For instance, sustaining a given lifestyle is usually more important and less changeable than a large gift to one's alma mater. This is the sort of value weighting that incorporates utility into the assessment of investment objectives because happiness and peace of mind are not simple, quantitative measures. (The difference between success and happiness is worth pondering. Success is getting what you want in life, while happiness is wanting what you get.)
How much regret will you feel if you end up with 20% over your goal? How much regret will you feel if you're 20% under your goal? Ben Graham's great concept, the Margin of Safety, is essential for long-term investment success because it's not just the end-point that matters; the pathway matters too. Charles Dickens articulated this reality as “Micawber's law”: Income of £20 and expenses of £19 and 19 pence equal happiness, while income of £20 and expenses of £20 and tuppence equal misery.
This is why most endowments now use a moving-average spending rule discipline of 5% after covering inflation. (The percentage was originally worked out by James Tobin of Yale to provide intergenerational equity by recognizing investment experience and new gifts and the impact of inflation. His friend David Swensen developed the most rigorous and complete articulation and implementation of solving for the three-way reality in management of the Yale University endowment. He explained this in his great book, Pioneering Portfolio Management.)
Yes, investors are right to be serious students of the markets, particularly the extremes that entice and ensnare, but markets are only part of the recommended curriculum. Know thyself is even more important, and all investors will want to recognize the central lessons of behavioral finance:
If Mr. Market can't get you to be overly optimistic by showering you with good news and promises, then can he worry and even scare you with bad news and threats? We all have weaknesses, and Mr. Market knows where and when to push our buttons.
Risk tolerance differs for each investor. And the worst time to learn your risk tolerance—the limit to which you can absorb risk and uncertainty without experiencing the anxieties that produce irrational behavior—is when you are there for the first time or are without preparation. This is why fire drills make sense, and why investors will benefit from studying past market behavior, so they can estimate their own “what if” behavior and protect themselves from getting caught outside their personal comfort zone.
Utility likewise differs for each investor. Having $100,000 extra is not the reciprocal of being short by $100,000 any more than having an extra gallon of gas in the tank when you arrive at your destination is the reciprocal of running out of gas 16 miles from home. Each investor will benefit from an explicit understanding of his or her utility function.
Time, the Archimedes lever in investing, wants to be your helpful friend if you can be patient. If you invested $1.00 in the S&P 500 through the 1990s, you would have made $5.59. But if you missed just 90 big days in that decade, you would have lost money. And if you missed just 60 months out of the 75 years ending in 2000, your total return for that long, long period would be zero. The obvious lesson: To get the long-term return you have to be there when the market moves—and these best days or months occur when least expected.
If all investors followed the investment policies that would be best for them, they would have no conflicts with any other investor's best-fit policies. The only assumption behind this categorical statement is that investors differ in risk tolerances and in time horizon, and emotional capacities, and the consequences of just these two types of difference produce an almost infinite variety of combinations of risk restraints, investment objectives, and investment capabilities. For each set of variables, there is an optimal best-fit investment policy.
With the beginning and the ending reasonably well defined, the investor can then try to estimate the most reasonable expectation for investments over the intervening time span to see how realistic it is to expect the starting funds to achieve the investor's objectives after that most probable investing experience. If this three-part cut-and-try process works, fine. If the fund comes up short, the investor will want to consider seriously saving more or reducing the aggregate goals.
The really hard part is not figuring out the best feasible investment policy combination. While it takes some time and analytical discipline, this part of the problem-solving is straightforward engineering. The really hard part is managing ourselves: our expectations and our interim behavior. As Walt Kelly's Pogo puts it: “We have met the enemy and it is us.” Most investors are too optimistic about the long run and much too optimistic about how well they will do compared to the averages, so they set themselves up for disappointment.
Even worse, most investors do harm to their longer-term investment results by trying and trying again to do “better”: changing managers and changing asset mix at the wrong time and in the wrong way. Disappointed by a few years of poor performance from managers we were attracted to by their good performance of prior years, we miss the recovery when the manager's type of stocks does well, and we catch the down-leg of the newly chosen manager whose results are simply regressing to the mean. The record on market timing is even worse. Investors' self-destructive attempt to do better is shown starkly in the results of the mutual fund investor switching noted above.
Where can and should the individual or the institutional investor turn for counsel on the long-term investment policy that is right for that particular individual or that specific institution? Where would you send your mother's best friend? Where would you send the trustees of your alma mater? Where would you want your grandchildren to go for investment counseling? Is it really just caveat emptor?
If you find these questions difficult to answer, you may share with me the view that the investment profession has an important opportunity to develop our capabilities in investment counseling and make them much more widely available. Three parts of investment policy are important:
The importance of each investor concentrating on winning the winner's game with sensible long-term investment policies is matched by the daunting realities of changes in the investor's environment that make the loser's game all the harsher and more forbidding. Changes in the way institutional portfolios are managed are substantial. And because they are simultaneous, they are compounding.
Because the business consequences of the Loser's Game are becoming recognized by investment managers, they are moving toward the norm of hugging the index and charging full fees for managing high-turnover portfolios based on largely the same information—with little chance of outperforming competitors who are equally skillful, have equal access to information, and are equally quick to respond to changing information or interpretation by buying or selling.
Making your own plan is the best, and probably the only, way to win the winner's game. And it's easy if you can ignore that rascal Mr. Market and the crowd that follows him as they play the Loser's Game. By correctly defining each investor's unique investment objectives and determining the realistic investment policies for achieving those objectives, each investor can avoid the Loser's Game and win his or her own Winner's Game.
Source: The Journal of Portfolio Management, Spring, 2003.