People that follow me know that “Winning the Loser’s Game” by Charles Ellis is my favorite book on investing. Ellis approaches investing from a different viewpoint that is refreshingly different, and absolutely spot on, than most investment experts. I consider three positions especially significant in promoting successful investing.
We now know to focus not on rate of return but on the informed management of risk.
Simply put, investors cannot control the market. They can control investment expenses and investment risk. Controlling investment risk often focuses on an investment’s volatility and the correlation of one investment’s performance with other investments in one’s portfolio.
Far too often, investors are not provided with correlation of returns data for their investments. Yes, correlation of return data does change, but so does an investment’s return and standard deviation.
From an investment perspective, the goal should be to effectively diversify one’s investment portfolio to hopefully minimize the risk of large losses. By combining investments that have different levels of correlation of returns, that behave differently in different market and/or economic conditions, we can reduce the risk of large losses.
Far too many investors are fooled into thinking that effective diversification can be accomplished by simply holding different types of investments within the same asset class. For instance, I reportedly see investors whose portfolio consists of large cap equity mutual funds, small cap equity mutual funds, and perhaps an international equity fund.
What such investors do not understand is that over the past decade or so, all equity funds, both domestic and international, have consistently shown a high correlation of returns, generally in excess of 90 percent correlation. As a result, many investors are holding portfolios that provide little or no protection against downside risk, large losses.
To quote Donald Trump, “focus on the downside, the upside will take care of itself.”
Even though most investors see their work as active, assertive, and on the offensive, the reality is and should be that stock investing and bond investing are primarily defensive processes.
This perspective confuses a lot of people, but it is absolutely true. Money that is lost investing cannot fully participate in the market’s subsequent recovery. As I tell my clients, you cannot get ahead if you have to spend all of your time catching up.
When I speak to groups, I often use the 50/50 example to stress the importance of defensive investing. The 50/50 example is simple – if I lose 50 percent of my investment in one year and realize a 50 percent return the next year, what is the status of my portfolio? Many people will say I’m back at zero. But if I lose 50 percent, and then realize a 50 percent return the next year, my portfolio has still suffered a 25 percent loss (50 percent + (50 percent of 50 percent)).
The impact of investment losses and the amount of return required to fully recover from such losses can be easily calculated. The formula is [1/1 – amount of investment loss] – 1, then multiply by 100. For instance, a 50 percent loss would require a return of 100 percent to fully recover such loss. [[(1/.50), or 2, less 1] x 100]
Keep in mind, however that an investor suffers an opportunity loss by having to use that market return to recover from the loss rather than being able to use that return to increase their portfolio’s worth. Investing defensively requires giving up a little upside potential, however it acknowledges that the market is cyclical and helps reduce downside risk.
Defensive investing simply makes sense from a proactive perspective. As the Chinese philosopher observed, “the best way to manage anything is by making use of its nature.”
So rational investors should consider the true cost of fees charged by active managers not as a percentage of total returns, but as the incremental fee as a percentage of risk adjusted incremental returns above the market index.
This concept is at the heart of my entire practice and is the fundamental concept behind my proprietary fiduciary prudence metric, the Active Management Value Ratio™ (AMVR). The AMVR is a simple cost/benefit metric that effectively allows anyone to quantify the prudence of a mutual fund, using just incremental cost and incremental return as the input data for simple subtraction and division calculations.
The value of using incremental cost and incremental returns is that it allows us to analyze an investment in terms of additional cost and return beyond what an investor can achieve by using a less expensive alternative investment providing similar returns, for example passively managed index funds.
Many investors are surprised to learn that many actively managed mutual funds fail to outperform comparable index funds. Using the AMVR, many investors are surprised to learn that even when an actively managed fund does outperform an index fund, the incremental costs associated with actively managed mutual funds often exceeds the fund’s incremental return, thus resulting in a net loss.
Bottom line, using incremental costs and incremental returns provides us with information that is often hidden by simply looking at a mutual fund’s stated total return and stated standard deviation data.
Most library systems have a copy of “Winning the Loser’s Game,” or are willing to do an interlibrary loan to get a copy from another library. If you are serious about investing and protecting your financial security, I would strongly take a couple of hours and enjoy Charles Ellis’ excellent advice.