An Investor’s Worst Enemy
The investor’s chief problem – and even his worst enemy – is likely to be himself.
– Benjamin Graham
If beating the market was as easy as becoming a top tennis player, there would be a lot more Serena Williams and Roger Federers. The lessons of acquiring skill in tennis are crucial for investors to heed.
Like most boys growing up in New York City, I spent much of my childhood and teenage years with a basketball glued to my hand. I was a fairly good athlete and even managed to make my college basketball team as a freshman.
That is not saying much.
Baruch College was a Division III school, and I mostly sat at the end of the bench. By the end of the season, I had accumulated more splinters than minutes played. I also played lots of baseball, softball and football. Unfortunately, since there were not many tennis courts in the Bronx, I did not get to play tennis often.
At the age of 25, I moved to San Francisco. Everyone there played tennis, so I became a tennis player. After a relatively short time, because of my athletic skills, I became a decent weekend player. However, I was often frustrated by the fact that players consistently beat me even though I was the better athlete. It was particularly frustrating when I lost to a player who was decades older.
After about 20 years, I figured it out.
While I was a better athlete, they were better tennis players – and there is a big distinction between the two.
With this “revelation,” I finally decided to attend a tennis clinic. At the end of the week, each of the participants got to play for an hour with the tennis pro. During my session, I learned something that dramatically improved my tennis game. It also provided me with an insight about games in general.
Like most weekend players, my weaker shot was the backhand. During a rally, the tennis pro hit a shot deep into my backhand corner. He then came to the net, putting even more pressure on me. Amazingly, I hit a great passing shot that landed deep in the court and just inside the line. After making that shot, the pro called me to the net. I was sure he was going to compliment me. Instead, what he said was, “That shot will be your worst enemy.” He explained that while it was an exceptional shot, it was not a high-percentage one for a good weekend player like me. Remembering how good that shot felt, I tried to repeat it. Unfortunately, I was rarely successful. He pointed out that while he could make that shot perhaps 90% of the time, I was likely to make it less than 10% of the time. The pro then asked me if I’d rather make great shots or win matches. Up until that point, I thought that one led to the other.
The pro taught me otherwise.
He explained that in the game played by weekend warriors like me, most points are not won by hitting shots that can’t be returned by the opponent. Instead, most points are lost when balls are hit into the net, long, or outside the lines in a failed attempt to hit those exceptional winning shots. That is why this type of strategy produces what is called a “loser’s game.” The pro was also polite enough to say that it’s not the people who play the game who are losers.
It’s the strategy they’re following.
To improve my results, the pro told me that to find the winning strategy, I had to understand the type of game I was playing. Since, unlike professional tennis players, I’m not capable of consistently hitting winning shots, I was playing a loser’s game. Instead of trying to hit winners (and likely hitting the ball long, wide, or into the net), he said I should just try to safely hit the ball back, with a bit of pace, and use the middle of the court – and let the opponent play the loser’s game. Recognizing the brilliance of his advice, I immediately put it to work, with astonishingly good results. I was now regularly beating players who had previously beaten me.
What does tennis have to do with investing?
Consistently successful investing requires a successful strategy. The majority of individual investors (and most professionals) try to beat the market. They do so by attempting to uncover individual securities they believe the rest of the market has somehow mispriced (the price is too high or too low). They also try to time their investment decisions so that they are buying when the market is “undervalued” and selling when it is “overvalued.” Such a strategy is known as “active portfolio management.”
With the same infrequency of my great tennis shots, these active portfolio managers will occasionally make a killing. On the other hand, over the long run, the likelihood is they’ll lose (underperform) more often than they’ll win (outperform). Thus, the evidence demonstrates that while the winning strategy in tennis is different for amateurs than professionals, the winning strategy in investing is the same for all investors, whether they are individuals or institutions.
In tennis, the winning strategy is to not play the loser’s game. In investing, the winning strategy is also to not play the loser’s game, but to accept market returns by investing in passively managed funds.
There is an overwhelming body of evidence, such as that provided by the annual Standard & Poors’ active versus passive scorecards (SPIVA), that demonstrates that the vast majority of professional investors succeed at beating passive benchmarks about as often as I was able to hit a shot the teaching pro was unable to return (it was the only point I won that day). The reason they fail is that they are trying to hit that great shot (finding mispriced securities) instead of just safely getting the ball back (accepting market returns).
If the professionals fail with such regularity, what are the odds you will succeed?
In the face of such overwhelming evidence, the puzzling question is why people keep trying to play a game they are likely to lose. There are four explanations: (1) Because Wall Street and most of the financial media want to conceal the truth, investors are unaware of the evidence; (2) While the evidence suggests that playing the game of active management is the triumph of hope over wisdom and experience, hope does spring eternal – after all, a small minority do succeed; (3) Active management is exciting, while passive management is boring; and (4) Investors are overconfident – a normal human condition, not limited to investing. While each investor might admit that it’s hard to beat the market, each believes he will be one of the few who succeed.
University of Chicago professor Richard Thaler and Yale professor Robert Shiller noted that “individual investors and money managers persist in their beliefs that they are endowed with more and better information than others, and that they can profit by picking stocks.”1 Ninety percent think they’re above average. This insight helps explain why individual investors believe they can pick stocks that will outperform the market, time the market, and identify the few active managers who will beat their respective benchmarks. Gus Sauter, who managed a wide array of index funds for Vanguard and one actively managed fund, provided this insight: “Like everybody else in this industry I have an ego large enough to believe I’m going to be one of the select few that will outperform.”2
Perhaps the most amusing example of overconfidence is the Mensa investment club (though it could not have been amusing to them, as their results make the Beardstown Ladies investment club look like Warren Buffett). Mensa is a club that limits its membership to those individuals whose IQs are in the top 2%. If anyone has a right to be confident in their intellectual capacity to achieve superior investment results, it is the members of Mensa.
The June 2001 issue of Smart Money reported that over the prior 15 years, the Mensa investment club returned just 2.5%, underperforming the S&P 500 Index by almost 13% per annum. Warren Smith, an investor for 35 years, reported that his original investment of $5,300 had turned into $9,300. A similar investment in the S&P 500 Index would have produced almost $300,000. One investor described their strategy as “buy low, sell lower.” The Mensa members were overconfident that their superior intellectual skills would translate into superior investment returns.
Overconfidence is very expensive.
The example of the Mensa investment club proves the wisdom of financial historian and author Peter Bernstein’s insight: “The essence of investment theory is that being smart is not a sufficient [emphasis mine] condition for being rich.”3
Investors would be wise to heed Wall Street Journal columnist Jonathan Clements, who made the following observation: “Beat the market? The idea is ludicrous. Since very few investors manage to beat the market, but in an astonishing triumph of hope over experience millions of investors keep trying.”4 Overconfidence provides the explanation for this behavior. Investors may even recognize the difficulty of the task; yet, they still believe they can succeed with a high degree of probability. As author and personal finance journalist James Smalhout put it, “Psychologists have long documented the tendency of Homo sapiens to overrate his own abilities and prospects for success. This is particularly true of the subspecies that invests in stocks and, accordingly, tends to overtrade.”5
Gary Belsky and Thomas Gilovich, authors of the wonderful book, Why Smart People Make Big Money Mistakes, reached the following conclusion:
Any individual who is not professionally occupied in the financial services industry (and even most of those who are) and who in any way attempts to actively manage an investment portfolio is probably suffering from overconfidence. That is, anyone who has confidence enough in his or her abilities and knowledge to invest in a particular stock or bond (or actively managed mutual fund or real estate investment trust or limited partnership) is most likely fooling himself. In fact, most such people – probably you – have no business at all trying to pick investments, except perhaps as sport. Such people – again, probably you – should simply divide their money among several index mutual funds and turn off CNBC.6
Having been presented with several tales that provide the logic and evidence on why passive investing is the winner’s game, hopefully you will allow wisdom and experience to triumph over hope and overconfidence. If, however, you are still undecided, consider the following: It is estimated that the revenues of the institutions that make their living from the capital market exceeds $150 billion per year. This is the portion of the returns that the markets provide that is removed (from your pockets) by financial intermediaries. That amount might approach as much as 2% per annum of the total stock and bond markets!7 Consider these words of wisdom from author Ron Ross: “The people on Wall Street simply can’t imagine how they would make a living if they weren’t trying to beat the market. But that’s their problem, not yours. It’s not your responsibility to provide livelihoods for stock analysts. What’s rational on Wall Street isn’t usually aligned with the best interests of you as an investor.”8
The moral of the tale
To echo the sentiments of ex-Wall Street Journal columnist Jonathan Clements: If you want to see the greatest threat to your financial future, go home and take a look in the mirror.9 If you decide to play the loser’s game of active investing, the only people you will likely enrich are your financial advisor, your broker-dealer, the manager of the actively managed mutual fund or investment product in which you are investing, and the publisher of the newsletter, magazine or ratings service to which you subscribe.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
1 Jonathan Fuerbringer, “Investing It,” New York Times, March 30, 1997.
2 Robert McGough, “The Secret (Active) Dreams of an Indexer,” Wall Street Journal, February 25, 1997.
3 Peter Bernstein, The Portable MBA in Investment (Wiley, 1995).
4 Jonathan Clements, 25 Myths You’ve Got to Avoid (Simon & Schuster, 1998), p. 55.
5 James H. Smalhout, “Too Close to Your Money?” Bloomberg Personal, November 1997.
6 Gary Belsky and Thomas Gilovich, Why Smart People Make Big Money Mistakes (Simon & Schuster, 1999).
7 Peter L. Bernstein and Aswath Damodaran (editors), Investment Management (Wiley, 1998), p. 252.
8 Ron Ross, The Unbeatable Market (Optimum Press, 2002), p. 16.
9 Jonathan Clements, “Getting Going: Twenty Tips for No-Nonsense Investing,” Wall Street Journal, February 19, 2006.