Andrew Allentuck

Saturday, February 8, 2003

Winning the Loser's Game: Timeless Strategies for Successful
by Charles D. Ellis
182 pages
ISBN 0-07-138767-6.

Books of fundamental truth about investing - an activity which seems to defy the rules that are set down for it - are rare. Charles D. Ellis has crafted one. Author of ten previous books and scores of very serious articles on asset management, he has taught investment courses at the elitist of the elite Ivy League business schools, chaired the Association for Investment Management and Research (the outfit that gives out the Chartered Financial Analyst designation), and has been on the management boards of Harvard, Yale and NYU.

The problem all investors confront is that while stock returns exceed bond and bill returns over periods of 20, 30, 40 years or more, over shorter periods, there is no telling what stocks will do. Quoting Ben Graham's motto,"long-term investors must be careful not to learn too much from recent experience," Mr. Ellis sets down rules for investor who is prepared to follow fundamental rules of good financial stewardship:

*Stocks gain or lose from short term volatility, often because investors' enthusiasm or lack of it values shares higher or lower. But over long periods, the short term volatility in returns caused by the interest-propelled discount rate or investors' passion diminishes and the expected dividend stream, which is more stable, becomes ever more important.

*Short term performance has zero predictive power, yet, as Mr. Ellis observes, the U.S. fund rater Morningstar observes that all new investment money going into mutual funds goes to the top tier four and five star mutual funds. But in the year after the ratings are handed out, the winner's curse takes over and the prior year winners generally earn less than half as much as the broad market index. So annual high performance should be read not as an indicator to invest in a particular fund, but as a warning not to.

*Efforts to predict the market on the basis of price wiggles, volume wobbles, backtesting and backward looking math (econometrics, in a nutshell) don't work. The pattern of the market is that there is no pattern.

*The farther current events are from the mean at the centre of the bell curve of returns, the stronger the forces of mean reversion become, a process that unrelentingly pulls current data toward the centre and normalcy.

The normal return of U.S. stocks, adjusted for inflation, is 6.75 per cent per year. Since the returns from 1981 to 2001 were 13.3 per cent per year, the next 20 years should return only 0.6 per cent These poor returns could prevail in the next decade or two, as they did from 1901 to 1921 when the real average return of U.S. stocks was 0.2 per cent, as they did in the period from 1929 to 1949 when the return was 0.4 per cent, and as they did from 1966 to 1986 when the real return was 1.9 per cent.

What to do? The implicit advice is not to buy bonds, which tend not to compensate for inflation, but to invest in a broad stock index. Mr. Ellis is fond of the S&P 500 stocks, a good cross section of the U.S. large cap market, though he fails to acknowledge that, like the Dow 30, it is a list of popular and often interesting stocks that has growth stock characteristics through its market weighting mechanism. The Wilshire 5000, rally a 7,000 stock index that includes virtually all the capitalization of public companies in America, is a better choice.

Mr. Ellis' wisdom comes down to this: If you have decade to go before retirement, buy a major stock index, hold it, ignore transitory news, have faith, and hope you are not in a period of awful returns. If you are, you have the pleasure of knowing that professional managers who charge 1.5 per cent of assets in U.S.-based mutual funds and about 2.5 per cent of assets under management in Canada, will do little better.

Glum though this book may be, it is the closest thing to market truth since Burton Malkiel, who provides Mr. Ellis with a back cover adulatory blurb, published A Random Walk Down Wall Street thirty years ago. And while the perpetual optimist Abby Joseph Cohen provides another garland of praise on the cover (ignore her tooth fairy tiding; there is no tooth fairy in the market), the vision of Mr. Ellis is clear and likely right. Investing in a matter of faith in markets and good math. This is a book every investor from novice to lauded and even to incarcerated should read.