The Loser's Game
Warren Buffett, perhaps the greatest investor alive today, has an amusing way to describe his rules for investing:
Rule #1 — never lose money
Rule #2 — don’t forget rule #1
Although this may seem like an overly simple and conservative way to succeed, I hope to show you that these simple rules hold the key to successful investing for the vast majority of people: understand when you are playing a loser’s game and then play accordingly.
What do I mean by a loser’s game? Back in the 1960’s, an engineer from TRW did an exhaustive study of the game of tennis and found that it was not one game, but two: one game played by professionals and the other played by amateurs. Professionals, he found, won 80% of their points by making great shots. In other words, the winner of the game was determined by the winner’s actions. That’s a winner’s game. Amateurs, on the other hand, lost 80% of their points by making unforced errors—hitting the ball out of bounds or into the net, or double faulting. In other words, for amateurs, the winner of the game was determined by the loser’s actions. Hence the name, loser’s game.
Why is investing a loser’s game for the vast majority of people? Investing is a loser’s game because most people lose by making unforced errors. The record supports this claim. For example, over the last 19 years, the stock market as a whole has gone up around 12% per year. So, if you started with $1,000 19 years ago, you should have ended up with $8,500 from average performance. The average mutual fund investor, on the other hand, barely saw their money appreciate by 6% per year. Instead of ending up with $8,500, they ended up with around $3,000. Clearly, the average mutual fund investor lost. Perhaps you think professionals did better? Unfortunately, no. In fact, 80% of professional investors also failed to keep up with market averages. Now, why is that?
Most investors failed to keep up with the market because they were chasing performance. When you dig into the specific choices that mutual fund investors and professional money managers made, you find that they were continuously selling recent losers and buying recent winners. Unfortunately, the “losers” they were selling tended to do much better going forward than the supposed “winners” they were buying. Specifically, in 1999 they were selling Caterpillar and Fidelity Equity and Income and buying Webvan and Janus 20. What went wrong? They thought they were playing a winner’s game and were trying to hit great shots, but instead they were playing a loser’s game and causing their own unforced errors.
If investing is a loser’s game for most people, how do you win in a loser’s game? You win a loser’s game by not making mistakes. Let me use tennis as an example first to make my point. To win as an amateur in tennis, you need to first acknowledge that you are an amateur, and then you need to change your strategy. Instead of pursuing a strategy of making great shots, you need to become really good at keeping the ball in play. That way, you let your opponent have all the opportunities they need to make mistakes, thus handing you the win!
The same basic idea works for investing, too. First, you need to acknowledge whether you are in the top 20% of investors or the bottom 80%. If you are in the bottom 80%, you need to focus on not picking losers instead of trying to pick winners. You do this by buying index funds, or purchasing mutual funds or companies that have dependable, but unexciting, long term records that seem to be fool-proof. Stick with your choice over time instead of chasing performance and you’ll out-perform the vast majority of investors. Be honest with yourself about what you do and don’t know. If you don’t know anything about biotech, don’t buy it. If your uncle Harry gives you a stock tip and you don’t know what he’s talking about, don’t even think about acting on it.
Which brings me back to Warren Buffett’s rules for investing: Rule #1 – never lose money by acknowledging when you are playing a loser’s game and focus on not picking losers instead of trying to pick winners; Rule #2 – don’t forget Rule #1 by always being honest with yourself about what kind of game you are playing and by assuring yourself you can only win by sticking to your game.
Author: Michael Rivers, CFA, a Member of the Paladin Registry