God Bless Charles Ellis

I am often asked what I feel is the best investment book for investors and what one piece of advice I would give investors. Fortunately, the answer to both is the same – read “Winning the Loser’s Game” by Charles Ellis. The book is written in a style that anyone can understand and offers sound, practical advice for every level of investor, newbie or veteran.

When people come into my office, I think they expect to see volumes of investment related books. Instead they see just three investment books on my credenza – “Winning,” “The Intelligent Investor” by Benjamin Graham, and “A Random Walk Down Wall Street” by Burton Malkiel. In my opinion, those are the only three investment books an investor needs to be a successful investor.

I first read “Winning” back in its first edition in 1987, when it was titled as “Investment Policy.” The reason I chose “Winning” as my favorite investment book is that it introduced me to the concept of investment analysis using an investment’s incremental cost and incremental return, when Ellis advised investors that they

“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.”

Ellis pointed out that since investors could essentially obtain the market return through an inexpensive index fund, using incremental fees and returns allowed investors to get a better picture of what value, if any that an active manager provided

That concept has been the core element of my entire practice, as it allows investors to avoid unnecessary costs, which reduce an investor’s end return. Remember, each additional 1 percent of fees and other costs reduce an investor’s end return by approximately 17 percent over a 20 year period.

 

Using an actively managed mutual fund’s incremental costs and returns reinforces what study after study has shown, namely that the majority of actively  managed funds fail to outperform passively managed index funds. The SPIVA report (S&P Indices Versus Active) provides a biannual analysis comparing the performance of actively managed funds versus passive indices.

For the year ending on December 31, 2014, the actively managed funds once again posted consistent under-performance versus the indices. The 5 and 10 year under-performance percentage for all domestic mutual funds was 80.82 and 76.54 respectively. For domestic large cap funds, the 5 and 10 year under-performance percentage was 88.65 and 82.07 respectively. For domestic mid cap funds, the 5 and 10 year underperformance percentage was 88.65 and 82.07 respectively. For domestic small cap funds, the 5 and 10 year underperformance percentage was 86.55 and 87.75 respectively. Despite these facts, the investment options offered by most 401(k)/404(c) plans continue to be dominated by actively managed mutual funds.

Incremental analysis also allows an investor to see that in most cases, actively managed mutual funds either fail to provide any benefit at all, or that the fund’s incremental costs exceed any incremental return produced. In both cases, an investor loses money.

My metric, the Active Management Value Ratio 2.0™, uses a fund’s incremental return and incremental costs to evaluate the intrinsic value, if any of an actively managed mutual fund. The information needed to perform the calculations are available for free on various web sites. The calculation process only requires simple subtraction and division.

There is a saying in the investment industry – the public focuses on investment returns, investment professional focus on investment risk. while most modern investment books focus on returns since that is what interests the public, Ellis focuses on the importance of the effective management of investment risk in successful investing.

The great secret of success in long-term investing is avoiding serious, permanent loss….[M]anaging market risk is the primary objective of investment management….We now know to focus not on rate of return but on the informed management of risk.

Few investors seems to realize the true impact of investment losses. When I do presentations, I often ask the audience a sample question to impress upon them the impact of investment losses. The question poses a situation where an investor suffers a 50 percent loss in year 1, followed by a 50 percent gain in year 2. The audience is then asked where the investor stands versus his beginning position.

Most of the audience will say that the two 50 percent numbers cancel each other out, so the investor is back where he began, with no loss. However, the correct answer is that the investor is still down 25 percent. If we assume that the investor started off with $1,000, lost 50 percent to $500, then gained 50 percent, or $250, on the $500, the investor only has $750, or $250 (25%) less than what he started with.

To calculate the gain needed to offset investment losses, an investor can use the following equation: [(1/(1-amount of loss))-1] times 100. For example, it takes a return of 100 percent to offset a loss of 50 percent. (1/(1-.50)) x 100 or (2 x 100) equals 00 percent.

The bear market of 2008 saw investor losses of 40 percent or more. To recover from a loss of 40 percent, an investor needed to achieve a return of  approximately 67%.

Ellis discusses several risk management options, including effective asset allocation/diversification. Many investors mistakenly believe that they are effectively diversified by holding various classes of mutual fund, e.g., large class growth, small cap value. However, since most domestic equity-based mutual funds share a high correlation of returns, owning various classes of domestic equity-based mutual funds does not provide an investor with the downside protection against losses that true diversification provides.

If you truly care about investing to protect you and your family’s financial security, do yourself a favor by finding “Winning the Loser’s Game” and investing a couple of hours in reading it. By doing so you will discover the truth of our blog’s tagline, “the power of the informed investor.”

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