Investing is a loser’s game. Or at least that is what Charles D Ellis, former chair of the board of the Institute of Chartered Financial Analysts and former adviser to Singapore’s sovereign wealth fund GIC, believes.
In 1975, Ellis wrote a paper titled “The loser’s game”, in which he drew a thought-provoking analogy between investing and the sport of tennis.
Ellis presented two distinct strategies in tennis: playing a winner’s game and a loser’s game. In professional tennis, characterised as the winner’s game, elite athletes with exceptional skills and strategies compete to win through their superior abilities. The outcome often hinges on who can outperform their opponents. Errors are seldom made by these top athletes.
On the other hand, there is the loser’s game, played by amateur players. The emphasis shifts from winning through skill to minimising unforced errors, such as hitting the ball out of bounds or into the net. In this game, victory often goes to the player who makes fewer mistakes, essentially making oneself the greatest opponent.
Ellis extended this depiction to the investing game. He argued that investing has become a loser’s game, because it is now a competitive industry dominated by institutional investors armed with large research staffs and access to extensive information.
Compared to the early days of the stock market, any superior ability that previously allowed investors to play the winner’s game and produce significant market outperformance cannot be solely relied on due to the level playing field.
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This means that the edge individual investors once had, due to their unique insights or access to information, has diminished against the extensive resources of institutional investors.
As a result, it has become increasingly difficult for individual investors to consistently outperform the market based on skill alone.
With Ellis’ characterisation of investing as a loser’s game in mind, how then can investors win in the stock market? Remember, the strategy for winning is to reduce mistakes. Let’s explore three key unforced errors in investing and how investors can avoid them.
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1. Lack of diversification
It is tempting for investors to bet big when they come across an attractive company. Allocating a significant portion of their capital allows them to obtain potentially outsized returns.
However, over-concentration and failing to diversify can expose investors to unnecessary risks. Betting too much on a single company or sector is like relying solely on your powerful serve in tennis.
Sure, it might earn you some impressive aces, but if your opponent catches on and adapts, you are left scrambling. In short, if that specific investment underperforms, you are in trouble.
Contrary to over-concentration, diversification, like a well-rounded game, involves a solid serve, reliable volleys and a consistent backhand. Even if one aspect of your game is not working perfectly, the other aspects can help you stay competitive.
In the same way, a diversified portfolio helps spread investment risk across different companies, sectors and geographical regions. While individual investments may experience volatility, the overall diversified portfolio may exhibit smoother performance as losses in one investment may be offset by gains in another.
This “smoothing” of performance can also lead to behavioural benefits by helping investors stay disciplined during periods of market volatility. Knowing that their portfolio is diversified and well-balanced can reduce the anxiety and temptation to make impulsive investment decisions based on short-term market movements.
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What then constitutes over-concentration or adequate diversification in a stock portfolio? There is no single correct answer, as this very much depends on each investor’s experience and risk appetite. However, there are some guidelines to consider.
To begin, it is important to set boundaries. For instance, a 10-stock portfolio — with an average allocation of 10% for each position — would likely be too concentrated for most investors. On the other end, a 50-stock portfolio would be too tedious to manage. Within these limits, investors can and should experiment with the average allocation size that works for them.
It would be advisable to start new positions smaller than the average allocation size. It takes time to get to know a company better, and research does not end when investors initiate a position. Therefore, having some skin in the game without risking too much at the beginning is prudent.
Additionally, investors should consider their overall allocation and risk exposure to an industry, even if the portfolio appears sufficiently diversified in terms of allocation to individual companies.
For example, a 5% allocation each to eBay, Walmart, Shopify and Best Buy would mean a 20% allocation to the US retail industry. The portfolio may be hit hard should a recession occur in the US.
2. Do your own research
Investing in a company based on a headline, hearsay, or a bank-issued buy report, is not research; it is a recipe for investing failure. It is like stepping onto the tennis court without practising your serves or knowing your opponent’s weaknesses.
Research, at a minimum, involves reading company quarterly and annual reports, analysing financial statements, and listening to the quarterly earnings calls.
More extensive research includes studying management actions, conducting competitor analysis and interviewing customers.
Just as a tennis player studies an opponent’s game, research enables investors to gain a deeper understanding of a company’s business model, products or services, competitive advantages, industry dynamics, financial health, management quality and potential risks.
This understanding forms the basis for making informed investment decisions. It prevents investors from blindly following market trends or adopting the herd mentality.
Instead of relying solely on others’ opinions or recommendations, investors can form their own independent judgments based on objective analysis and data. More importantly, thorough research can give investors confidence in their investment thesis and conviction in their decisions.
This conviction is essential for the investors to stay disciplined during market volatility.
3. Do not make emotional decisions
The two most common and dangerous emotions in investing are greed and fear. When markets are rising and peers are humble-bragging about their phenomenal returns, it is hard not to feel like a fool for staying out of the market.
Greed often leads investors to chase returns without considering the associated risks. It is like trying to hit a winner with every shot in tennis — eventually, you will make a costly error.
Greed can also cause investors to take on excessive leverage to amplify potential returns, overlook fundamental analysis, and rely solely on momentum or market speculation.
When greed fuels herd mentality, market bubbles form, ultimately resulting in crashes.
Conversely, fear-induced selling occurs when investors panic during market downturns. They sell their investments at low prices to avoid further losses and pain, akin to a tennis player abandoning their strategy and hitting wild shots under pressure. This locks in losses and prevents their portfolios from benefitting from the eventual market recovery.
So, how can investors mitigate the influence of these emotions?
Firstly, it is important to develop a long-term perspective. Investors need to remind themselves that market cycles, often punctuated by large bubbles and painful crashes, are as sure as night follows day.
Second, investors should stick to a wellthought-out investment plan driven by solid fundamental analysis. Elements of the plan can include allocating capital at regular intervals over time. This will ensure that not all capital is allocated during market peaks and that investments are still sensibly made during market lows.
Sound analysis can help investors avoid seemingly attractive but ultimately speculative investments such as cryptocurrencies and NFTs. There is no denying that coping with greed and fear is difficult, especially for newer investors.
Unfortunately, the journey of mastering these emotions often involves experiencing painful investing decisions during market tops and bottoms.
However, over time, investors should be able to cope with these emotions better and possibly even take advantage of opportunities that arise during periods of extreme fear.
Conclusion
Ellis’ analogy of investing and amateur tennis sheds light on the challenges investors face in today’s competitive market environment.
Just as amateur players seek to minimise unforced errors rather than outperform opponents with superior skill, investors must focus on avoiding unforced errors to achieve long-term success.
Sufficient diversification, thorough research, and controlling emotions are essential elements of a successful strategy in winning this loser’s game.
Cedric Ho is the portfolio manager of MAD Partnership, an investment service at PhillipCapital that invests clients’ capital in global equities
