Ellis. Winning the Loser's Game: Timeless Strategies for Successful Investing

Ellis established the basic premise that institutional investors cannot beat the market, for they compose the market. He differentiated a winner's game from a loser's, "in a winner's game the outcome is determined by the correct actions of the winner. In a loser's game, the outcome is determined by the mistakes made by the loser" (pp. 4-5). Ellis ascribed the reason for losing to the institutional investors, "they are the most important part of the problem" (p. 8). Ellis continued by asserting, "active investing is at the margin always a negative-sum game. Changing investments among investors would by itself be a zero-sum game, but costs such as commissions, expenses, and market impact must be deducted. Net result: a negative-sum game" (p. 9).

Ellis interjected an optimistic note, in this rather bleak picture, that "every investor can be a winner. All we need to do to be long-term winners is to reorient ourselves and concentrate on realistic long-term goal setting, sound policies to achieve our goals, and the requisite self-discipline, patience, and fortitude required for persistent implementation" (p. 10).

Ellis identified four strategies investors employ in their attempt to beat the market: "1. Market timing 2. Selection of specific stocks or groups of stocks 3. changes in portfolio structure or strategy 4. An insightful, long-term investment concept or philosophy" (p. 11). None of these proved to create a winning option, according to Ellis. He proposed the alternative of index funds, which had the advantages of "higher returns . . . lower fees . . . lower operating costs . . . lower taxes . . . lower risk of errors or blunders . . . lower anxiety about errors or blunders" (pp. 30-31).

Regarding the congruence between investment goals and strategy, Ellis observed a paradox. He saw a discrepancy between an investment manager's short-term actions and an investor's long-term objectives. He urged investors to have their advisor accomplish four tasks when seeking investment advice: "(1) understanding the client's real needs, (2) defining realistic investment objectives that can meet the client's realistic needs, (3) establishing the right asset mix for each portfolio, and (4) developing well-reasoned, sensible investment policies" (p. 43) that match objectives, strategy, and adherence to the strategy. Observing these principles improve the potential of portfolio performance, "policies that position the portfolio to benefit from riding with the main long-term forces in the market" (p. 43).

Six Questions
Ellis enunciated six questions each investor should ask an investment manager.
"First, what are the real risks of an adverse outcome, particularly in the short run . . .
Second, what are the probable emotional reactions of clients to an adverse experience? . . .
Third, how knowledgeable are you about investments and the vagaries of financial markets? . . . Fourth, what other capital or income resources does the client have and how important is the particular portfolio to the client's overall financial position? . . . Fifth, are there any legal restrictions on investment policy? . . . Sixth, are there any unanticipated consequences of interim fluctuations in portfolio value that might affect policy" (pp. 46-47).

Benign Neglect
The two factors that influence investment performance include time and risk. Ellis described time as the "Archimedes lever in investing" (p. 55). He continued, "the trade-off between risk and reward is driven by one key factor: time" (p. 55). These two factors determine the ratio of fixed income investment and equity investment. Risk entails three elements: "the real risk-free rate of return . . . a premium over the risk-free rate of return to offset the expected erosion of purchasing power caused by inflation . . . a premium over the inflation-adjusted risk-free rate of return to compensate investors for accepting market risk" (pp. 67-68). Furthermore, Ellis explained four types of risk: "price . . . interest rate risk . . . business risk " (pp. 67-68). The forth type of risk, market risk, "market risk pervades all investment. It can be increased by selecting volatile securities or by using leverage, and it can be decreased by selecting securities with low volatility or by keeping part of a portfolio in cash equivalents. But it cannot be avoided or eliminated. It is always there. Therefore, it must be managed" (p. 68). Two actions add a degree of control: "deciding deliberately what level of market risk to establish as the portfolio's basic policy and (holding to the chosen level of market risk" (p. 73).

Ellis stressed the advantage of index funds: "Such a fund provides a convenient and inexpensive way to invest in equities, with the riskiness of particular market segments and specific issues diversified away" (p. 70).

Writing an investment policy
Defining an investment policy, Ellis considered the fundamental task of the investor. An investment policy “is to establish useful guidelines for investing that are genuinely appropriate to the realities both of your own investment objectives and of the realities of the investment markets. These are the internal and external realms of investing, and investment policy must be designed to work well in both realms” (p. 89). The policy articulates the investor’s risk tolerance, objectives, and the equities that fit with the risk and objectives. The investment advisor explains the external factors, the markets and economic realities that affect the investor’s goals. “Investment policy is the explicit linkage between your long-term investment objectives and the daily work of your investment manager” (p. 90), stated Ellis. He recommended that the investor have the policy in writing.

Ellis elaborated on three policy facets: “the level of market risk to be taken . . . whether the level of risk is to be sustained or varied as markets change . . . whether individual stock risk or group risk is to be taken or avoided and the incremental rate of return which such risks, when taken, are expected to produce in the portfolio” (p. 90). If an investment advisor differentiates himself from the general market, that is an index fund, the investor needs to understand how he differs. Ellis stipulated how an advisor might differ: “by betting heavily on a few stocks, by favoring a particular stock market sector, or by investing heavily in cash if he thinks stocks are overpriced” (p. 90). Furthermore, understanding his execution, “whether continually as part of a long-term strategy or occasionally as a short-time tactic . . . and, most important, why he is confident that he will achieve favorable incremental results by taking these actions” (p. 91). With this insight, an investor can assess the advisor’s competence.

Ellis offered five standards by which an investor can evaluate an investment policy:

“1. Is the policy carefully designed to meet your real needs and objectives?
2. Is the policy written so clearly and explicitly that a competent stranger could manage the portfolio and conform to your intentions?
3. Would you have been able to sustain a commitment to the policies during the most troubling capital markets that have actually been experienced over the past 50 years—when conventional wisdom was surely most opposed?
4. Would the investor or professional investment manager have been able to maintain fidelity to the policy over the same periods despite intense daily pressure?
5. Would the policy, if implemented, have achieved your objectives?” (pp. 94-95).

Performance measurement, chapter 14 of Ellis’ work, has two basic principles—that the market, similar to any statistical phenomenon, tends to conform to the regression to the mean” (p. 97). The second principle stipulated that an investor should compare the portfolio with those of the same type—small cap with small cap and growth with growth.
Ellis reiterated the need to measure long-term results to determine true success.

Managing Managers
Ellis described how knowledgeable investors manage their advisors. The investor should attend to formulating an investment policy, internally and externally, in keeping with his or her decision-making process. Internal and external understanding constitutes the first and second steps of the process. Third, find a manager to execute your plan. Fourth, stick to the plan regardless of external realities. To maintain the relationship, Ellis suggested quarterly or semiannual meetings with an agenda, all documents. Ellis continued, “each meeting should begin with a careful review of the investment manager’s mission—the agreed-upon investment policies of the portfolio through which the manager is expected to accomplish the mutually intended long-term objective—to see if any modification in either objective or policy is appropriate” (p. 116). If not, reaffirm the policy document. “Discussion of specific portfolio operations—purchases and sales of specific securities—should be on an exception basis and should be brief” (p. 116). “The balance of the meeting time, usually another half hour, can best be devoted to a thoughtful and detailed discussion of almost any topic of importance to both the client and the manager as a way to increase shared understanding” (p. 117).

At least once a year the main topic should be a candid review—led by the client—of the client’s overall financial situation and the context in which the investment portfolio fits” (p. 117).

A written summary of perhaps three to five pages should be prepared and distributed after each meeting and kept for future reference. One suggestion would be to have alternating meetings summarized by the client and the investment manager” (pp. 117-118).

Questions an investor should ask for an actively managed portfolio include: “which managers will outperform the market for many years into the future? . . . can you identify the future’s favored few today? . . . will you make the right decisions and take action at the right time? . . . if you do select a superior manager, will that manager stay superior or will the assets managed grow? . . . (p. 120).

Among the rights of a client investor, according to Ellis, the investor “can select specialist managers skilled in each of the several different kinds of investing wanted . . . clients can diversity against the risk of one manager’s investment concept being out of tune with the overall market” (p. 122). Instead of many managers to diversity and reduce risk, Ellis pointed to index funds as a means to accomplish the same end.

The various decision-making sections of a portfolio entail equity mix, active versus passive management, advisor choice, portfolio policy and alternations. Emphasis on section 1, equity mix, increase the odds of success in comparison to portfolio alternations, section five.

Individual Investor’s 10 Commandments
1. “Don’t speculate
2. Save
3. Don’t do anything in investing primarily for “tax reasons”
4. Don’t think of your home as an investment
5. Never do commodities
6. Stockbrokers . . .their job is not to make money for you . . . their job is to make money from you
7. Don’t invest in new or “interesting” investments
8. Don’t invest in bonds because you’ve heard that bonds are conservative or for safety
9. Write out your long term goals
10. Don’t trust your emotions” (pp. 141-142)

Concentrate your investment in index funds for 401(k) plans.

Questions to Ask to Plan for the Future
“During retirement, how much income do I want to have each year in addition to Social Security and my employer’s pension benefit? . . . How many years will I be I retirement? What spending rule am I ready to live with and live by? . . . How much capital will I need to provide amply for retirement? . . . After insurance, what capital will I need—inflation-adjusted—to cover full health care for my spouse and myself? . . . How much capital do I want to pass on to each member of my family? . . . How much capital do I wish to direct to my philanthropic priorities?” (p. 156).

“Average returns for each type of investment have been approximately as follows:
Stocks 4 1/2 percent
Bonds 1 1/2 percent
T-bills 1 ¼ percent

Steps to Develop a Strategy
“Ask representatives of three organizations this question in writing: ‘Over the past 20 years, the stock market’s average annual total return has been X percent. Starting at the stock market’s present level, what average annual rate of return from today’s market level would your firm expect over the next 20 years? Next question: Over the next 1-, 5-, and 20-year periods, what rate of inflation do you expect?” (p. 157). When you have their answers, take the average of their answers. You’ll now have two crucial estimates of the future: The nominal rate of return for the stock market and the amount you will have to adjust nominal returns to estimate the real (inflation-adjusted) rates of return.
Any funds that will stay invested for 10 years or longer should be in stocks
Any funds that will be invested for less than two to three years should be in “cash” or money market instruments

“Prepare a complete inventory of your investment assets, including the following:
Investment in stocks and bonds
Equity in your home
Assets in any retirement plans"

Ellis' Suggested Reading List (pp. 174-175)

Berkshire Hathaway Annual Reports
The IntelligentInvestor by Benjamin Graham
Bogle on Investing, Jack Bogle
Pioneering Portfolio Management, David Swensen
Why SmartPeople Make Big Money Mistake--and How to Correct Them, Gary Belsky and Thomas Gilovich
The Crowd, Gustave LeBon
The Only Investment Book You'll Ever Need, Andrew Tobias
A RandomWalk down Wall Street
An Investor's Anthology
Wealthy and Wise, Claude Rosenberg



Ellis, C. D. (2002). Winning the loser's game: Timeless strategies for successful investing. NewYork: McGraw-Hill.