QUALIPORT
Why Stock Picking Is A Loser's Game

By Maynard Paton (TMFMayn)
January 3, 2002

Carburton Street, London -- "Every investor will benefit from the classics found in this volume."-- Warren Buffett.

The volume in question is The Investor's Anthology, a compilation of "original ideas from the investment industry's greatest minds". Contributors include Warren Buffett, Philip Fisher, Ben Graham, Charles Mackay and (believe it or not) Hans Christian Anderson. But perhaps one of the best features in the book comes from Charles Ellis, one of the book's co-producers.

Winners and losers

Ellis states that most competitive activities can be divided into two types of "games" -- the Winner's Game and the Loser's Game. He uses tennis as an example. Although everybody plays the sport with the same equipment, rules and scoring, Ellis points out that tennis is actually two different games: one game is played by professionals; the other is played by everybody else.

The distinguishing feature between the two games is how the points are scored. In "expert" tennis, the majority of points are won -- the skilled professional will beat his opponent by playing great, successful shots. Here, victory is due to winning the most points.

However, "amateur" tennis is literally a different ballgame. Brilliant shots, long rallies and miraculous recoveries are few and far between. Instead, the ball is all too often hit into the net or out of the court. Thus majority of points are lost, so to speak. The amateur player seldom beats his opponent. Instead, victory in the amateur game usually goes to who lost the least points.

So how does your amateur player succeed at tennis? Ellis simply suggests: "avoid mistakes". In other words, be conservative, keep the ball in play, and give your opponent plenty of opportunities to blunder his way to defeat.

Although your opponent may play the odd fantastic shot, his general efforts to win will, unfortunately for him, only increase his error rate. In short, by not trying too hard and losing less, you can become an amateur victor.

Disagreeable numbers

But how does the tennis lesson help with successful stock picking?

Ellis highlights a feature of the investment industry that the Motley Fool has often emphasised:

"The disagreeable numbers from the performance measurement firms say there are no managers whose past performance promises they will outperform the market in the future. Looking backward, the evidence is deeply disturbing: 85% of professionally managed funds underperformed the S&P 500 during the past 10 years. And the median fund's rate of return was only 5.4% -- about 10% below the S&P 500."

(It's worth noting that Ellis' text was written in 1975!)

Going by the evidence produced by Ellis and others over the years, stock market investment is generally a Loser's Game. While there are a handful of winners (i.e. those who generally beat the index), given the (continuing!) underperformance of managed funds, most institutional investors are akin to the hopeless amateur tennis player.

Those "disagreeable numbers" that Ellis refers to suggests to investment managers: "Don't do anything, because if you do, it is on average a mistake". I'm sure that message is appropriate to most private investors, too.

Become less of a loser

So how can amateur investors -- that is, those investors who aren't blessed an inordinate amount of stock picking talent -- try and win at this Loser's Game?

Ellis gives three points to consider:

* Be sure you are playing your own game: In other words, know yourself, know your investment strategy and know your boundaries. Draw a circle of competence, as Buffett would say. Keep your portfolio mistakes to a minimum by sticking with the familiar.

* Keep it simple:  Keep to straightforward businesses that have obvious investment attractions. Don't try and be too clever. Avoid companies where the chances of making a mistake are increased -- turnarounds, businesses in fast changing industries, and so on. Also, keep to obvious and immediate valuation measures. The more esoteric your valuation model, the more mistakes it'll contain.

Ellis uses this great quote from golfer Tommy Armour: "Simplicity, concentration, and economy of time and effort have been the distinguishing features of great players' methods, while others have lost their way to glory by wandering in a maze of details".

* Concentrate on your defences: Almost all the information and comment in the investment industry is orientated towards the purchase of shares. Thus the competition in the buying decision process is intense. So try and concentrate on selling instead. Almost all of the really big investment trouble you're going to experience in the next year is in your portfolio right now. Reduce some of those mistakes now, and you might come out a winner in the Loser's Game.

More: Where Troubles Lies In 2002 | Obvious And Immediate Valuation