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1975-1984

The Loser s Gam e

Charles D. Ellis

D

sa g r e ea b l e da t a a r e s t r e a m i ng ou t o f t he c om-

pute r s of BeCker Securi t ies and Mer r i l l Lyn ch

a nd a ll t he o t he r pe r f o r ma nc e me a sur e me n t fi r ms.

O ve r a nd ove r a nd ove r a ga i n , t he se f a c t s a nd

f i gu r e s i n f o r m us t ha t i nve s t me n t ma na ge r s a r e

fa i l ing to per form. Not only a re the na t ion ' s lead-

ing por t fol io managers f a l l ing to produce pos i t ive

absolute r a tes of r e tur n (a f te r a ll , i t' s been a long,

long bear marke t ) but they a re a l so fa i l ing to

p r oduc e pos i t i ve

relative

r a t e s o f r e t u r n . Con t r a r y

to the i r of t a r t icula ted goa l of outper forming the

ma r ke t a ve r a ge s , i nve s t me n t ma na ge r s a r e no t

be a t i ng t he ma r ke t : The m a r ke t i s be a t i ng t he m.

F a c e d w i t h i n f o r ma t i on t ha t c on t r a d ic t s w ha t

t he y be li e ve, hu m a n be i ngs t e nd t o r e spo nd i n one

of two w ays . Som e wi ll a ssimi la te the informat ion,

c ha ng i ng i t - - a s oys t e r s c ove r a n obnox i ous g r a i n

o f s i l i c a w i t h na c r e - - so t he y c a n i gnor e t he ne w

know l e dge a n d h o l d o n t o t he i r f o r me r be li ef s ; a nd

o t he r s w i l l a c c ep t t he va l id i t y o f t he ne w i n f o r ma -

t ion . I ns t e a d o f c ha ng i ng t he me a n i ng o f the ne w

data to f i t the i r o ld concept of r ea l i ty , they adjus t

t he i r pe r c e p t i on o f r e a l i t y t o a c c ommoda t e t he

i n f o r ma t i on a nd t he n t he y pu t i t t o use.

P syc ho log i s ts a dv i se us t ha t t he m or e i mpor -

t a n t t he o l d c onc e p t o f r e a li t y i s to a p e r so n- - t he

mo re imp or tan t i t i s to h is sense of se l f -es teem and

se nse o f i nne r w or f l l - - t he mor e t e na c i ous ly he w i ll

ho l d on t o t he o l d c onc e p t a nd t he m or e i n s i s te n t l y

he wi l l a ss imi la te , ignore or r e jec t new evidence

tha t conf l ic t s wi th I r i s o ld and fami l ia r concept of

t he w or l d . Th i s be ha v i o r i s pa r t i c u l a r l y c ommon

a m ong ve r y b r i gh t pe op l e be c a use t he y c a n so

eas i ly deve lop and a r t icula te se l f -per suas ive logic

t o j u s ti f y t he c onc l us i ons t he y w a n t t o ke e p .

F o r e xa mpl e , mos t i n s t it u t iona l i nve s t m e n t

ma na g e r s c on t i nu e t o be l ie ve , o r a t l ea s t s a y t he y

be l ie ve , t ha t t he y c a n a n d soon w i ll a ga in "o u t pe r -

f o r m t h e m a r k e t . " T h e y w o n ' t a n d t h e y c an ' t. A n d

the purpose of th i s a r t ic le i s to expla in why not .

My e xpe r i e nc e w i t h ve r y b r i gh t a nd a r t ic u l a te

inv es tm ent ma nag ers i s tha t the i r skil ls a t ana lys is

and logica l ext rapola t ion a re very good, of ten

Reprinted from Finandal Analysts Journal July~August 1975):19-

26.

superb, but tha t the i r br i l l iance in extend ing logica l

e x t r a po l a t i on d r a w s t he i r ow n a t t e n t i on f a r a w a y

f r om t he some t i me s e r r one ous ba s i c a s sumpt i ons

upo n w hi c h t he i r s c he me s a r e ba se d . M a j o r er r o r s

i n r e a son i ng a nd e xpos i ti on a r e r a r e l y f oun d i n t he

logica l dev e lop me nt of th i s ana lys is , but in s tead l ie

wi thin the premise i t se l f . This i s wha t wor r ied

Ma r t i n Lu t he r . I t 's w h a t

The Best and The Brightest

is

al l about . I t 's wh a t l i f ted LTV above $100; wh y the

Empe r o r w e n t f o r da ys w i t hou t c l o t he s ; a nd w hy

com edians a nd sc ience f ic tion wr i te r s a re so ca re ful

f i r s t t o e s t a b l i sh t he "p r e mi se " a nd t he n qu i c l dy

d i ve r t ou r a t t e n t i on f r om i t so t he y c a n e l a bora t e

the per suas ive de ta i l s of deve loping " logic ."

T h e i n v e s t m e n t m a n a g e m e n t b u s i n e s s ( i t

should be a profess ion but i s not ) i s bui l t upon a

s imple and bas ic be l ie f : Profess iona l money man-

a ge r s c a n be a t t he ma r ke t . Tha t p r e mi se a ppe a r s t o

be false .

I f the premise tha t i t i s f eas ible to outper form

t he ma r ke t w e r e a c c e p t e d , de c i d i ng how t o go

a bou t a c h i e v i ng suc c e s s w ou l d be a ma t t e r o f

s t r a ight forward logic . F i r s t , the marke t can be

represented by an index, such as the S&P 500.

Since this is a passive and public l ist ing, the

succ e ss f ul , ma n a ge r ne e d on l y r e a r r a nge h i s be t s

di f fe rent ly f rom those of the S&P " ' shil l ." H e can

be an ac t iv is t in e i the r s tock se lec t ion or marke t

t iming, or both . S ince the manager wi l l want h is

"be ts" to be r ight most of the t ime , he wi l l a ssem-

ble a grou p of br ight , w e l l edu ca ted , h igh ly mot i -

va t e d , ha r d w o r k i ng yo un g pe op l e , a nd t he i r c ol -

lec t ive purpose wi l l be to bea t the marke t by

"be t t i ng a ga i ns t t he house " w i t h a "good ba t t i ng

a ve r a ge . "

The be l ie f tha t ac t ive managers can bea t the

marke t i s based on two assumpt ions : (1) l iquidi ty

of fe red in the s tock marke t is an adva ntage , and (2)

ins t i tu t iona l inves t ing i s a Winner ' s Game.

The unhappy thes is of th i s a r t ic le can be

br i ef l y s t at e d : O w i ng t o i mpor t a n t c ha nge s i n t he

pa s t t e n ye a r s , t he se ba s i c a s sumpt i ons a r e no

longer t rue . On the cont ra ry , marke t l iquidi ty i s a

liability r a t he r t ha n a n asset, and ins t i tu t iona l inves-

tor s wi l l , over the long te rm,

underperform

t he

Financial Analysts Journal / January-February 1995

95

© 1995, AIMR®

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1975-1984

m ark e t b ecau s e m o n ey m an ag em en t h as b eco m e a

L o s e r ' s G am e .

Before dem ons t ra t in g wi th mathemat ica l ev i -

d e n c e w h y m o n e y m a n a g e m e n t h a s b e c o m e a

Loser ' s Game, we sh ould c lose o f f the one path o f

escape for those who wi l l t ry to ass imi la te the

fac t s . They may argue tha t th i s analys i s i s unfa i r

b ecau s e s o m u ch o f t h e d a t a o n p e r fo rm an ce

comes f rom bear market exper ience , g iv ing an

adverse b ias to an evaluat ion of the long- term

capabi li t ies o f mana gers wh o hav e por t fo l io be tas

above 1 .0 . "Of course , " they wi l l concede wi th

d r i p p i n g i n n u en d o , " t h es e i n t e r e s t i n g an a l y s es

m ay h av e l e s s t o s ay ab o u t d y n am i c fu n d m an ag -

e r s o p e ra t i n g i n a d ecen t m ark e t . " Pe rh ap s , b u t

can t h ey p re s en t u s w i t h ev i d en ce t o s u p p o r t t h e i r

h o p es ? C an t h ey s h o u l d e r t h e b u rd en o f p ro o f?

A f t e r m an y h o u r s o f d i s cu s s i o n w i t h p ro t e s t i n g

m o n ey m an ag e r s a l l o v e r A m er i ca an d i n C an ad a

an d E u ro p e , I h av e h ea rd n o n ew ev i d en ce o r

p e r s u as i v e ap p ea l f ro m t h e h a rd j u d g m en t t h a t

fo l lows the ev idence presen ted below. In b r ief , the

"problem" is not a cycl ical aberrat ion; i t i s a

long- term secu lar t rend .

The bas ic charac ter i s t i cs o f the env i ronment

wi th in which ins t i tu t ional inves tors mus t opera te

h av e ch an g ed g rea t ly i n t h e p as t d ecad e . T h e m o s t

s ign i f i can t change i s tha t ins t i tu t ional inves tors

have become, and wi l l con t inue to be , the domi-

nan t fea ture o f the i r ow n envi ronm ent . Th i s

ch an g e h as i m p ac t ed g rea t l y u p o n a l l t h e m a j o r

fea tures o f the inves tment f i e ld . In par t i cu lar ,

ins t i tu t ional dominance has conver ted market l i -

qu id i ty f rom a source o f

profits

to a source o f

costs,

and th i s i s the main reason beh ind the t rans forma-

t io n o f m o n e y m an ag em en t f ro m a Wi n n e r ' s G am e

to a Loser ' s Game.

B efore an a l y z in g w h a t h ap p e n ed t o co n ve r t

ins t i tu t ional inves t ing f rom a Winner ' s Game to a

L o s e r ' s G am e , w e s h o u l d ex p l o re t h e p ro fo u n d

d i ff e r en ce b e t w een t h es e t w o k i n d s o f " g am es . " In

making the concep tual d i s t inc t ion , I wi l l use the

wri t ings o f an em inent sc ient i st , a d i s t ingu i she d

his to r ian , and a reknowned educator . They are ,

respect ive ly , Dr . Simon Ramo of TRW; naval h i s -

to r i an , Admira l Samuel El l io t Morr i son ; and pro-

fess ional go l f ins t ruc tor , Tommy Armour .

Simon Ramo iden t i f i ed the crucia l d i f ference

b e t w een a Wi n n e r ' s G am e an d a L o s e r ' s G am e i n

h i s excel l en t book on p lay ing s t ra tegy ,

Extraordi-

nary Tennis for the Ordinary Tennis Player. Over a

p e r i o d o f m an y y ea r s , h e o b s e rv ed t h a t t en n i s w as

n o t one g a m e b u t two. O n e g am e o f t en n i s i s p l ay ed

by profess ional s and a very few g i f t ed amateurs ;

the o ther i s p layed by a l l the res t o f us .

A l t h o u g h p l ay e r s i n b o t h g am es u s e t h e s am e

equipment , d ress , ru les and scor ing , and conform

to the same e t iquet t e and cus toms , the bas ic

natures o f the i r two gam es are a lmos t en t i re ly

different . After extensive scient i f ic and s tat is t ical

analys is , Dr . Ramo s um me d i t up th i s way: Pro-

fess ional s win poin t s ; amateurs lose poin t s . Profes -

s ional t enn i s p layers s t roke the ba l l wi th s t rong ,

wel l a imed sho t s , th rou gh long and of te n exci t ing

ral l ies , unt i l one player is able to drive the bal l just

b ey o n d t h e r each o f h i s o p p o n en t . E r ror s a r e

s e l d o m m ad e b y t h es e s p l en d i d p l ay e r s .

Exper t t enn i s i s what I ca l l a Winner ' s Game

For the ten years ending December 3 , 1974, the funds in the Becker Secunties sample had a median

rate of return of 0.0 percent. The S&P total rate of retum over the same pedod was 1.2 percent per

annum. (Within the Becker sample, the high fund's annual rate of return was 4.5 percent, the first quartile

fund's retum was 1.1 percent, the median 0.0 percent, the third quartile 1.1 percent and the low fund's

annual rate of retum 5.6 percent.)

Unfortunately, the relative performance of institutionally managed portfolios appears to be getting worse.

Measuring returns from trough to trough in the market, the institutionally managed funds in the Becker

sampler are falling farther and farther behind the market as represented by the S&P 500 Average. It

appears that the

costs

of active management are going up and that the

rew rds

rom active management

are going down.

S&P 500 Becker Institutional

Average Median Shortfall

Last thre e market cycles 5.3% 4.1% (0.8%)

(9/30/62 to 12/31/74)

Las t two market cycles 2.1% 0.4% (1.7%)

(12/31/66 to 2/31/74)

Las t single market cycle 2.2% (0.3%) (2.5%)

(9/30/70 to 12/31/74)

Data:

Becker Securities 1974 Institutional Fu nds Evaluation Service.

96

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1975-1984

b ecau s e t h e u l t im a t e o u t co m e i s d e t e rm i n ed b y t h e

act ions o f the winner. Victory is due to winning more

points than the opponent win s-- no t, as we shal l see in

a moment , s imply to ge t t ing a h igher score than

t h e o p p o n en t , b u t g e t t i ng t h a t h i g h e r s co re b y

winning poin t s .

Amateur t enn i s , Ramo found , i s a lmos t en-

t i rely different . Bri l l iant shots , long and exci t ing

ra l l i es , and seemingly mi racu lous recover ies are

few and far be tw een . On the o ther hand , the bal l i s

fa i rly o f ten h i t into the n e t o r ou t o f bou nds , and

double fau l t s a t serv ice are no t uncommon. The

am a t eu r d u f f e r s e l d o m beats h i s o p p o n en t , b u t h e

beat s h imsel f a l l the t ime. The v ic to r in th i s game

of t enn i s ge t s a h igher score than the Opponent ,

bu t he ge t s tha t h igher score

because his opponent is

losing even more points.

As a scient is t and s tat is t ician, Dr. Ramo gath-

ered data to t es t h i s hypothes i s . And he d id i t in a

v e ry c l ev e r w ay . In s t ead o f k eep i n g co n v en t i o n a l

game scores - - -"Love," "Fi f t een Al l , " "Thi r ty -Fi f -

t e e n , " e t c . - ~ a m o s i m p ly c o u n t e d p o i n ts

won

ver-

sus po in t s

lost.

A n d h e re i s w h a t h e fo u n d . In

exper t t enn i s , abou t 80 perce n t o f the po in t s are

won; in ama teur t enn i s , abo ut 80 percen t o f the

poin t s are lost. In o ther words , p rofess ional t enn i s

i s a Wi n n e r ' s G a m e- - t h e f in a l o u t co m e i s d e t er -

mine d b y the ac t iv i t ies o f the winner--and am a t eu r

tenn i s i s a Loser ' s Game--- the f ina l ou tcome i s

determ ine d by the ac t iv i ti es o f the loser. T h e t w o

games are , in the i r fundamenta l charac ter i s t i c , no t

a t a l l the same. They are oppos i t es .

From th i s d i scovery of the two k inds o f t enn i s ,

Dr . Ramo bui lds a comple te s t ra tegy by which

ord inary t enn i s p layers can win games , se t s and

matches again and again by fo l lowing the s imple

s t ra tegem of los ing l ess , and l e t t ing the opp one nt

defea t h imsel f.

Dr . Ram o expla ins tha t i f you c hoose to win a t

t e n n i s - - a s o p p o s e d t o h a v i n g a g o o d t i m e - - t h e

s t ra tegy for winn ing i s to avo id mis takes . The w ay

to avo id mis takes i s to be conservat ive and keep

the bal l in p lay , l e t t ing the o ther fe l low have p len ty

o f ro o m i n w h i ch t o b l u n d e r h i s w ay t o d e fea t ,

b ecau s e h e , b e i n g an am a t eu r ( an d p ro b ab l y n o t

hav ing read Ramo 's book) wi l l p lay a los ing game

an d n o t k n o w i t .

He wi l l make er rors . He wi l l make too many

errors . Once in a whi le he may h i t a serve you

can n o t p o s s i b l y h an d l e , b u t m u ch m o re f r eq u en t l y

he wi l l double fau lt . Occas ional ly , he m ay vo l ley

bal l s pas t you a t the ne t , bu t more of ten than no t

they wi l l sa i l fa r ou t o f boun ds . He wi l l sl am bal l s

in to the ne t f rom the f ron t cour t and f rom the back

cour t . His gam e wi l l be a rou t ine ca ta logue of gaf fs ,

goofs and gr ief .

He wi l l t ry to beat you by winning , bu t he i s

n o t g o o d en o u g h t o o v e rco m e t h e m an y i n h e ren t

advers i t i es o f the gam e i t sel f . The s i tua t ion do es

not a l low h im to win wi th an ac t iv i s t s t ra tegy and

he wi l l ins tead lose . His ef for t s to win m ore po in t s

wi ll , unfor tuna te ly fo r h im, on ly increase h i s e r ror

ra te. A s Ramo ins t ruc t s us in h i s book , the s t ra tegy

for winn ing in a loser ' s game i s to lose l ess . Avoid

t ry ing too hard . By keep ing the ba l l in p lay , g ive

the Opponent as many oppor tun i t i es as poss ib le to

make mis takes and b lunder h i s way to defea t . In

br ief, by los ing l ess beco me the v ic to r .

In his thoughtful t reat ise on mil i tary science,

Strategy and Compromise,

A d m i ra l M o r r i s o n m ak es

the fo l lowing po in t : " In warfare , mis takes are

inevi table. Mil i tary decis ions are based on est i -

m a t e s o f th e en em y ' s s t r en g t h s an d i n t en ti o n s t h a t

are usual ly fau l ty , and on in te l ligence tha t i s never

comple te and of ten mis lead ing ." (This sounds a

grea t deal l ike the inves tment bus iness . ) "Other

th ings be ing equal , " concludes Morr i son , " the

s ide tha t makes the fewes t s t ra teg ic er rors wins the

w a r . "

War , as we a l l know, i s the u l t imate Loser ' s

Game. As Genera l Pat ton sa id : "Let the o ther poor

dum b b as tard lose h is l ife fo r h is co unt ry ." Gol f i s

an o t h e r L o s e r ; s G am e . T o m m y A rm o u r , i n h i s

g rea t b o o k How to Play Your Best Golf All the Time,

s ays : " T h e w a y t o w i n i s b y m ak i n g f ew er b ad

s h o t s . "

Gamb l ing in a cas ino wher e the ho use t akes a t

l eas t 20 percen t o f every po t i s obv iou s ly a Loser ' s

G am e . S t u d p o k e r i s a L o s e r ' s G am e b u t N i g h t

Basebal l wi th deuces , t rays and one-eyed Jacks

" w i l d " i s a Wi n n e r ' s G am e .

Camp aign ing for e lec ted of f ice i s a Loser ' s

Game: The e lec tora te se ldom votes for one of the

can d i d a t e s b u t r a t h e r

against

the o ther candidate .

Profess ional po l i t i c i ans adv i se the i r candidates :

" H e l p t la~ v o t e r s f i n d a w a y t o v o t e against the

o ther guy , and you ' l l ge t e l ec ted ."

Recent s tud ies o f p rofess ional foo tbal l have

foun d tha t the mo s t e f fec tive defens ive p la toon

members p lay an open , ad hoc , en terpr i s ing , r i sk-

tak ing s ty le- - the p roper s t ra tegy for a Winner ' s

G am e- -w h i l e t h e b es t o f f en s i v e p l ay e r s p l ay a

carefu l , "by the book" s ty le tha t concen t ra tes on

avoid ing er rors and e l iminat ing uncer ta in ty ,

which i s the requ i s i t e game p lan for a Loser ' s

Game. "Keep i t s imple , " Said Vincen t Lombard i .

T h e re a r e m an y o t h e r L o s e r ' s G am es . So m e ,

l ike ins t i tu t ional inves t ing , used to be Winner ' s

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1975-1984

G a me s i n t he pa s t , bu t ha ve c ha nge d w i t h t he

passage of t ime in to

Loser s Games.

For example , 50

years ago, only very brave , ve ry a thle t ic , ve ry

s t r ong w i l l e d young pe op l e w i t h good e ye s i gh t

had the nerve to t ry f ly ing an a i rplane . In those

glor ious days , f ly ing was a Win ner ' s Gam e. But

t i me s ha ve c ha nge d a nd so ha s f l y i ng . I f you go t

in to a 747 today, and the pi lo t came aboard wear -

ing a 50-miss ion ha t wi th a long, whi te s i lk sca r f

a r ound h i s ne c k , you ' d ge t o f f . Those pe op l e do

no t be l ong i n a i r p l a ne s a ny l ong e r be c a use f l yi ng

a n a i r p l a ne t oda y i s a Lose r ' s G a me . T oda y , t he r e ' s

only one w ay to f ly an a i rplane . I t ' s s imple : Don ' t

ma ke a ny mi s t a ke s .

Pr ize f ight ing s ta r t s out as a Winner ' s Game

a nd be c ome s a Lose r ' s G a me a s t he f i gh t

p r ogr e s se s . I n t he f i r s t t h r e e o r f ou r r ounds , a

r e a ll y s t r ong pun c he r t r ie s f o r a knoc kou t . The r e -

a f te r , pr ize f ight ing i s a grue l l ing contes t of endu r -

a nc e to s e e w h o c a n su r v i ve t he mos t pun i s hme n t ,

w h i l e t he o t he r f e l l ow ge t s so w or n ou t t ha t he

l i tera l ly dro ps to defea t .

Expe r t c a r d p l a ye r s know t ha t a f t e r s e ve r a l

r o u n d s o f p l ay , g a m e s l ik e G in R u m m y g o t h r o u g h

a "pha se c ha nge " a f t e r w h i c h d i sc a r ds no l onge r

i mpr ove t he r e l a t i ve pos i t i on o f t he d i s c a r d i ng

player . Dur ing th is la t te r phase , d i sca rds tend to

a d d m o r e s t r e n g t h t o t h e o p p o n e n t ' s h a n d t h a n

t h e y r e m o v e w e a k n e s s f r o m t h e h a n d o f th e d i s-

c a r de r . Th i s c ha nge s l ong ha nds o f G i n Rummy

into a Loser ' s Game, and the cor rec t s t r a tegy in

this la t te r phase of the gam e i s to eva lua te d isca rds

n o t i n t e r m s o f h o w m u c h g o o d t h e y w il l d o f o r

y o u r h a n d t o g et ri d o f t h e m , b u t r a t h e r h o w m u c h

g o o d t h e y m a y d o f o r y o u r o p p o n e n t .

Ma ny o t he r e xa mpl e s c ou l d be g i ve n , bu t

these wi l l suf f ice to make the dis t inc t ion be tween

Wi nne r ' s G a me s a nd Lose r ' s G a me s , t o e xp l a i n

w h y t he r e qu i s i t e p l a ye r s t r a t e gy i s ve r y d i f f e r e n t

f o r t he t w o k i nds o f ga me s , a nd t o show t ha t t he

f u n d a m e n t a l n a t u r e o f a g a m e c a n c h a n g e a n d t h a t

W i n n e r ' s G a m e s c a n a n d s o m e t i m e s d o b e c o m e

Lose r ' s G a me s . A nd t ha t ' s w ha t ha s ha ppe ne d t o

t h e M o n e y G a m e .

T h e M o n e y G a m e w a s a p h e n o m e n a l W i n -

ner ' s Gam e in the mid-1920s whe n John J. Raskob,

a p r omi ne n t bus i ne s s e xe c u t i ve , c ou l d w r i t e a n

a r ti c le f o r a popu l a r ma ga z i ne w i t h t he e nc our a g -

ing t i tl e "Ev ery bo dy Can Be Rich." The a r t ic le gave

a c ookbook r e c i pe t ha t a nybody c ou l d , t he o r e t i -

ca l ly , fo l low to r iches beyond the dreams of ava-

r ic e . The G r e a t C r a sh a b r up t l y r e ve r se d t he s i t ua-

t i on, a nd ma de i nve s t i ng a Lose r ' s G a me f o r ne a r l y

t w o de c a de s .

I t w a s d u r i ng t he se de c a de s o f t he t h ir t ie s a nd

for t ies tha t prese rva t ion of capi ta l , emphasis on

t he s a f e t y o f bonds , a nd sobe r s i de d c onve n t i ona l

w i s d o m c a m e t o d o m i n a n c e a n d t h e f o u n d a t i o n

w a s l a id f o r t he r e na i s sa nc e o f t he Wi nne r ' s G a me .

The bul l marke t of the 1950s gave dramat ic and

c ompe l l i ng e v i de nc e t ha t t he s i t ua t i on ha d

c ha nge d , t ha t b i g mone y c ou l d be ma de i n t he

ma r ke t . A nd t h i s ne w s a t t r a c t e d pe op l e w ho l i ke

t o m a k e b ig m o n e y - - p e o p l e w h o l ik e to w i n .

The pe op l e w ho c a me t o Wa l l S t r e e t i n t he

1960s ha d a l w a ys be e n- - a nd e xpe c t e d a l w a ys t o

b e - - w i n n e r s . T h e y h a d b e e n p r e s i d e n t s o f t h e ir

high school c lasses , va r s i ty team capta ins , and

hono r s t ude n t s . The y w e r e b r i gh t , a t t r ac t i ve , ou t -

go i ng a nd a mbi t ious . T he y w e r e w i l l ing t o w or k

ha r d a nd t a ke c ha nc e s be c a use ou r soc i e ty ha d

g i v e n t h e m m a n y a n d f r e q u e n t r e w a r d s f o r s u c h

be ha v i o r . The y ha d gone t o Y a le a nd t he M a r i ne s

a nd H a r va r d Bus i ne s s S c hoo l . A nd t he y w e r e

qu i c k t o r e c ogn i z e t ha t t he b i g Wi nne r ' s G a me w a s

be ing played in Wal l S t ree t .

I t was a g lor ious , wonder ful , euphor ic t ime . I t

w a s a t im e w h e n a l m o s t a n y b o d y w h o w a s s m a r t

a nd w i l li ng to w or k h a r d c o u l d w i n . A nd a l mos t a ll

of us d id .

The t r oub l e w i t h Wi nne r ' s G a me s i s t ha t t he y

t e nd t o s e l f - des t r uc t be c a use t h e y a t t r a c t too m uc h

a t te n t io n a n d t o o m a n y p l a y e r s - - a l l o f w h o m w a n t

t o w i n . ( Tha t ' s w h y go l d r u she s f i n ish ug l y . ) Bu t i n

t h e s h o r t ru n , t h e r u s h i n g i n o f m o r e a n d m o r e

p l a ye r s s e e k i ng t o w i n e xpa nds t he a ppa r e n t r e -

w a r d . A nd t ha t ' s w ha t ha ppe ne d i n Wa l l S t r e e t

dur ing th e 1960s. R iding the t ide of a bull marke t ,

i n s t i t u t i ona l i nve s t o r s ob t a i ne d suc h sp l e nd i d

r a t es o f r e t u r n i n e qu i ti e s t ha t mor e a nd mor e

m o n e y w a s t u r n e d o v e r t o t h e m - - p a r t i c u l a r l y i n

m u t u a l f u n d s a n d p e n s i o n f u n d s - - w h i c h f u e l e d

t he c on t i nua t i on o f t he i r ow n bu l l ma r ke t . I n s t i tu -

t i ona l i nve s t i ng w a s a Wi nne r ' s G a me a nd t he

w i nne r s k ne w t ha t by p l a y i ng it f a s te r , t he y w ou l d

increase the ra te of winn ings . But in the process , a

ba s i c c ha nge oc c ur r e d i n t he i nve s t me n t e nv i r on -

m e n t ; t h e m a r k e t c a m e t o b e d o m i n a t e d b y t h e

ins t i tu t ions .

In jus t t en year s , the marke t ac t iv i t ie s of the

i nve s t i ng i n s ti t u t ions h a ve gone f r om o n l y 30 pe r-

cent of to ta l publ ic t r ansac t ions to a whopping 70

pe r c e n t . A nd t ha t ha s m a de a ll the d i f f e r enc e . N o

l onge r a r e t he "N e w Br e e d on Wa l l S t r e e t " i n t he

mi nor i t y ; t he y a r e now t he ma j o r i t y . The p r o f e s -

s io n al m o n e y m a n a g e r i s n ' t c o m p e t i n g a n y l o n g e r

w i t h a m a t e u r s w h o a r e o u t o f t o u c h w i t h t h e

ma r ke t ; now he c ompe t e s w i t h o t he r e xpe r t s .

98 Financial Analysts Journal / January-February 1995

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1975-1984

I t 's an impress ive g r oup of compet i to rs . There

are 150 major ins t i tu t ional inves tors and ano ther

600 smal l and medium s ized ins t i tu t ions opera t ing

in the market a l l day , every day , in the mos t

i n t en s e l y co m p e t i t i v e w ay . A n d i n t h e p as t d e -

cade , these ins t i tu t ions have become more ac t ive ,

have developed l arger in -house research s t af fs ,

an d h av e t a p p ed i n to t h e cen tr a l s o u rce o f m ark e t

i n fo rm a t i o n an d fu n d am en t a l r e s ea rch p ro v i d ed

by ins t i tu t ional b rokers . Ten years ago , many

ins t i tu t ions wer e s t il l fa r ou t o f the ma ins t ream of

in tens ive management ; today such an ins t i tu t ion ,

i f any exists , would be a rare col lector 's i tem.

Compet i t ive ly ac t ive ins t i tu t ional inves t ing

has resu l t ed in sharp ly h igher por t fo l io tu rnover .

The typ ica l equ i ty por t fo l io tu rnover has gone

from 10 to 30 percen t . As we 've a l ready seen , th i s

accelera t ion in por t fo l io ac t iv ity p lus the g row th in

ins t i tu t ional asse t s and the sh i f t o f pens io n fun ds

t o w ard eq u i t i e s h av e i n c reas ed t h e p ro p o r t i o n o f

market t ransact ions o f ins t i tu t ions f rom 30 to 70

percen t which has , in tu rn , p roduced the bas ic

" p h as e ch an g e" t h a t h a s t r an s fo rm ed p o r t fo l i o

act iv i ty f rom a source o f incrementa l p rof i t s to a

major cos t , and tha t t rans format ion has swi tched

ins t i tu t ional inves t ing f rom a Winner ' s Game to a

Loser ' s Game.

T h e n ew " ru l e s o f th e g am e" can b e s e t o u t i n

a s imple bu t d i s t ress ing equat ion . The e lements

are these:

(a) Assume equi t i es wi l l re tu rn an average n ine

percen t ra te o f re tu rn .1

(b) A s s u m e av e rag e t u rn o v e r o f 30 p e rcen t p e r

a n n u m .

(c) As sum e a verage cos t s - - -dealer spre ads p lus

commiss ions- - -on ins t i tu t ional t ransact ions are

th ree perce n t o f the p r inc ipal va lue involved . 2

(d) A s s u m e m an ag em en t an d cu s t o d y f ee s to t al

0.20 per cent .

(e) Assume the goal o f the manager i s to ou tper-

form the averages by 20 percen t .

Solv e for "X ": (X . 9) - [30 . (3 + 3)] - (0.20)

= (120"9)

[30 • (3 + 3)] + (0.20) + (120 • 9)

X = 9

1 . 8 0 . 2 0 1 0 . 8

X =

12.8

X = -

9

X = 142%.

In p l a i n l an g u ag e , t h e m an ag e r w h o i n t en d s

to del iver n e t re tu rns 20 percen t be t t er than the

m ark e t m u s t ea rn a g ro s s r e t u rn b e fo re f ee s an d

transact ions costs ( l iquidi ty tol ls) that is more than

40 percen t be t t er than the market . I f th i s sounds

ab s u rd , t h e s am e eq u a t i o n can b e s o l v ed t o s h o w

that the ac t ive manager mus t beat the market

gross

b y 2 2 p e rcen t j u s t t o co m e o u t ev en w i t h t h e

m ark e t ne t .

In o ther word s , fo r the ins t i tu tional inves tor to

perform as wel l as , but no be t ter than , the S&P 500,

he mus t be suff i c ien t ly as tu te and sk i l l fu l to "ou t -

do" the market by 22 percen t . But how can ins t i -

tu t ional inves tors hope to ou tperform the market

b y s u ch a m ag n i t u d e w h en , i n e ff ect , t h ey are the

market today? Which managers are so wel l s t a f fed

and organ ized in the i r opera t ions , o r so p resc ien t

in the i r inves tment po l i c ies tha t they can hones t ly

expect to beat the o ther p rofess ional s by so much

on a sus ta ined bas i s?

The d i sagreeab le numbers f rom the perfor -

m an ce m eas u rem en t f i rm s s ay t h e re a r e no m an -

ag e r s w h o s e p as t p e r fo rm an ce p ro m i s es t h a t t h ey

wi l l ou tperform the market in the fu ture . Looking

backward , the ev idence i s deep ly d i s tu rb ing : 85

p e rcen t o f p ro fe s s io n a l l y m an ag ed fu n d s u n d e r -

perfo rme d the S&P 500 dur ing the pas t 10 years .

A n d t h e m ed i an fu n d ' s r a te o f r e tu rn w as o n l y 5 .4

p e rce n t - - ab o u t 1 0 p e rcen t be low the S&P 500.

M o s t m o n ey m an ag e r s h av e b een l o s i n g t h e

M o n e y G am e . A n d t h ey k n o w i t, ev en i f t h ey

cannot admi t i t pub l ic ly . Expecta t ions and prom-

i ses have come down subs tan t i a l ly s ince the mid-

1960s. Alm os t n obo dy s ti ll t a lks in t e rm s of beat ing

t h e m ark e t b y 2 0 p e rcen t co m p o u n d ed an n u a l l y .

A n d n o b o d y l i s t en s t o t h o s e w h o d o .

In t imes l ike these , the burden of p roof i s on

the person w ho says , " I am a winner . I can win the

M o n ey G am e . " B ecau s e o n l y a s u ck e r b ack s a

"winner" in a Loser ' s Game, we have a r igh t to

expect h im to exp la in exact ly what he i s go ing to

do and why i t i s go ing to work so very wel l . Th i s

i s n o t v e ry o f t en d o n e i n t h e i n v es t m en t m an ag e -

m en t b u s i n es s .

Does the ev idence necessar i ly l ead to an en-

t i re ly pass ive o r index por t fo l io? No, i t doesn ' t

necessar i ly l ead in tha t d i rec t ion . Not qu i t e . But

the "nu l l " hypothes i s i s hard to beat in a s i tua t ion

l ike this . At the risk of oversimplifying, the nul l

hypo thes i s says there i s no th ing there i f you can-

not f in d s tat is t ically s ignificant evid enc e of i ts

p re s en ce . T h is w o u l d s u g g es t t o i n v es t m en t m an -

ag e r s , " D o n ' t d o an y t h i n g b ecau s e w h en y o u t ry

to do someth ing , i t i s on average a mis take ." And

Financial Analysts Journal / January-February 1995

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1975-1984

i f you ca n ' t bea t the market , you cer ta in ly should

cons ider jo in ing i t. An index fund i s one wa y . The

d a t a f ro m t h e p e r fo rm an ce m eas u rem en t f i rm s

s h o w t h a t an i n d ex fu n d w o u l d h av e o u t p e r -

f o r m e d m o s t m o n e y m a n a g er s .

Fo r th o s e w h o a r e d e t e rm i n ed t o t ry to w i n t h e

Loser ' s Game, however , here are a few speci f i c

th ings they might cons ider .

F i rs t, b e s u re y o u a r e p l ay i n g y o u r o w n g am e .

K n o w y o u r p o l i c i e s v e ry w e l l an d p l ay acco rd i n g

to them al l the t ime. Admira l Morr i son , c i t ing the

Concise Oxford Dictionary, s ay s : " Im p o s e u p o n t h e

en em y t h e t i m e an d p l ace an d co n d i t i o n s fo r

f i g h t i n g p re f e r r ed b y o n es e l f . " S i m o n R am o s u g -

g es ts : " G i v e t h e o t h e r f e l l o w as m an y o p p o r t u n i -

t i es as poss ib le to make mis takes , and he wi l l do

SO.

Second , keep i t s imple . Tommy Armour , t a lk -

ing about go l f , says : "Play the sho t you 've go t the

grea tes t chanc e of p lay ing wel l . " Ramo says : "Ev-

e ry g am e b o l l s d o w n t o d o i n g t h e t h i n g s y o u d o

b es t , an d d o i n g t h em o v e r an d o v e r ag a in . " A r -

mour again : "Simpl ic i ty , concen t ra t ion , and econ-

o m y o f ti m e an d e f for t h av e b een t h e d i s t i n g ui s h -

ing fea tures o f the g rea t p layers ' meth ods , whi le

o t h e r s l o s t t h e i r w ay t o g l o ry b y w an d e r i n g i n a

maze of de ta il s .' " Mies Van der Rohe, the arch i t ec t ,

s u g g es t s , " L es s is m o re . " W h y n o t b r i n g t u rn o v e r

do wn as a de l ibera te , conscien t ious p rac t i ce? Make

few er an d p e rh ap s b e t t e r i n v es t m en t d ec i s i o n s .

S i m p li fy t h e p ro fe s s i o n a l i n v es t m en t m a n ag em en t

prob lem. Try to do a few th ings unusual ly wel l .

T h i rd , co n cen t r a t e o n y o u r d e fen s es . A l m o s t

a l l o f the in format ion in the inves tment manage-

m en t b u s i n es s i s o r i en t ed t o w ard p u rch as e d ec i -

s ions . The compet i t ion in making purchase deci -

s ions i s too good . I t ' s too hard to ou tperform the

o ther fe l low in buying . C oncent ra te on se l l ing

ins tead . In a Winner ' s Game, 90 percen t o f a ll

research ef for t should be spen t on making pur-

chase deci s ions ; in a Loser ' s Gam e, mos t research-

ers should sp end mos t o f the i r t ime mak ing se l l

deci s ions. Almo s t a l l o f the rea l ly b ig t rouble tha t

you ' re go ing to exper ience in the nex t year i s in

y o u r p o r t fo li o r ig h t n o w ; i f y o u co u l d r ed u ce s o m e

o f t h o s e r ea l ly b ig p ro b l em s , y o u m i g h t c o m e o u t

t h e w i n n e r i n t h e L o s e r ' s G am e .

Four th , don ' t t ake i t personal ly . Mos t o f the

p eo p l e i n t h e i n v es t m en t b u s i n es s a r e " w i n n e r s "

who have won a l l the i r l ives by being br igh t ,

a r t i cu la te , d i sc ip l ined and wi l l ing to work hard .

T h ey a r e s o accu s t o m ed t o s u cceed i n g b y t ry i n g

harder and are so used to be l i ev ing tha t fa i lu re to

succeed i s the fa i lu re ' s own fau l t tha t they may

t ak e i t p e r s o n a l l y w h en t h ey s ee t h a t t h e av e rag e

p ro fe s s i o n a l l y m an ag ed fu n d can n o t k eep p ace

w i t h t h e m ark e t an y m o re t h an J o h n H en ry co u l d

beat the s team dri l l .

There i s a c lass o f d i seases which are ca i l ed

" i a t rog en i c" m e an i n g t h ey a r e d o c t o r - cau sed . T h e

Chinese f inger cage and the modern s t ra igh t j acket

mos t t igh t ly g r ip the person who s t ruggles to

break free. Ironical ly, the reason inst i tut ional in-

v es t i n g h as b eco m e t h e L o s e r ' s G am e i s t h a t i n t h e

complex prob lem each manager i s t ry ing to so lve ,

h i s e f fort s to f ind a so lu t i on- -an d the ef for t s o f h i s

m an y u rg en t co m p e t i t o r s - - -h av e b eco m e t h e d o m -

inan t var iab les. A nd the i r e f fort s to beat the m arket

a r e n o l o n g e r t he m o s t i m p o r t an t p a r t o f th e

so lu t ion ; they are the mos t impor tan t par t o f the

p ro b l em .

Foo rNOTES

1. Use of 9 percent is for convenience only, and is an accom-

modation to its conventional acceptance. If time permitted,

I'd prefer to justify and then use a figure of, perhaps, 12

percent for the next decade which would reflect he market's

reflection of expected inflation.

2. This estimate was m ade by the senior trading partner of a

major institutional block rading firm. O ther expe rts indicate

this estimate may be low.

100 Financial Analysts Journal / January-February 1995