Whoever makes the fewest mistakes wins
To outperform markets, avoiding stupidity is easier than seeking brilliance.
In 1970, one of America’s leading scientists Simon Ramo wrote a quirky little book about his favourite pastime – tennis. The book, Extraordinary Tennis For the Ordinary Player, didn’t sell well initially but has since built a loyal following.
I’ve been a tennis player and fan all my life, so the book has obvious appeal. Ramo’s observations of the game, though, apply well beyond tennis.
Ramo suggests that tennis isn’t one game but two. Yes, players have the same equipment, rules and attire and conform to the same etiquette. Yet that’s where the similarities end. According to Ramo, there’s one game played by professionals and another game played by the rest of us.
Ramo thinks the outcome of an amateur tennis game is determined by the loser. Amateurs watch professionals play tennis and try to hit like them. They don’t have the ability to emulate their heroes, though. Their games have few long rallies, and even fewer brilliant strokes. Much more frequent is that balls are hit into the net or well outside the perimeter of the court. Double faults are common. Amateurs seldom beat their opposition; they most often beat themselves via their mistakes.
The game played by professionals is different. There are often long rallies of more than 20 shots with precise, hard hitting. Winners are frequent, whether it be service aces, groundstroke winners, dropshots and by coming into net to volley the ball away from the opponent. Not only are there winners, but there are also ‘forced errors’ – where professionals force their opponent into an error through good shot making of their own. Mistakes are far fewer in the professional game than the amateur game.
Testing the theory
As a good scientist, Ramo didn’t just observe; he tested his hypothesis. Instead of counting points in the conventional tennis manner of 15-love, 15-15, etc, he counted points won versus points lost. What he found was that in professional tennis, about 80% of the points are won; in amateur tennis, about 80% of the points are lost.
In Ramo’s eyes, this proves that professional tennis is a winner’s game – the outcome of a match is primarily determined by the shots played by the winner. Whereas amateur tennis is a loser’s game – the outcome is determined by the activities of the loser. Put simply, professionals win points, while amateurs lose points.
For Ramo, this means amateur players should adopt a game style that’s most suited to winning. Forget about trying to hit a spectacular winner like the professionals. Instead, focus on making less mistakes than your opponent. Hit shots well inside the lines, don’t do double faults by trying to hit serves too hard, and hit higher over the net to allow more margin for error.
Applying Ramo’s thoughts to markets
Ramo’s book has achieved some popularity primarily because of the publication of an article in an investment journal, titled ‘The Loser’s Game’, in 1975. Written by Charles Ellis, the article was subsequently turned into a book, Winning The Loser’s Game, which is now into its 8th edition.
In the book, Ellis applies Ramo’s theories to the investment world. Ellis suggests the investment game has changed from a winner’s game into a loser’s game. In the decades before 1975, the stock market was dominated by individual investors. This meant that someone who was willing to put in the work could potentially outsmart these investors and earn market-beating returns.
A big change happened in the 1960s as more professional investors started trading the stock market. By the mid-1970s, professional investors accounted for 90% of stock market activity. These investors worked 70 hours a week at their craft, and with so many of them entering the profession and with leading-edge technology at their fingertips, the stock market became more efficient and chances for outperformance largely vanished.
Winning the loser’s game
Echoing Ramo, Ellis suggests that the way you win a winner’s game is different to that of winning a loser’s game. In the stock market, as it’s become a loser’s game in Ellis’ view, there are two ways to win.
First, you can choose not to play the loser’s game. Even in 1975, Ellis had become an advocate of index investing - investing passively in the stock market rather than trying to beat it through active investing. Keep in mind that Vanguard, the behemoth of index investing, was only founded in the same year that Ellis’ original article came out.
The second way that you can choose to play the loser’s game is by losing less than your opponents via making less mistakes. Ellis advocates four ways to achieve this:
- Be sure you are playing your own game.
- Keep it simple. Make fewer and perhaps better investment decisions. Try to do a few things unusually well.
- Concentrate on your defences. “In a Winner’s Game, 90% of all research effort should be spent on making purchase decisions; in a Loser’s Game, most researchers should spend most of their time making sell decisions. Almost all of the really big trouble that you’re going to experience in the next year is in your portfolio right now; if you could reduce some of these really big problems, you might come out the winner in the Loser’s Game.”
- Don’t take it personally. Most people in the investment world are trained to be ‘winners’. A failure to succeed in a loser’s game won’t be your own fault so you shouldn’t take it personally.
What it means for today’s investors
What Ellis is really trying to say is that investing nowadays is incredibly hard and you need to have an edge if you want to succeed. I think there are some prospective edges that individual investors can pursue in today’s markets:
- Microcap investing or investing in microcap managers.
For outperformance, you need to go where there’s little competition. For companies worth less than $100 million, you’ll be investing alongside other individual investors. These smaller companies are too illiquid for institutional investors, so you’ll largely remove them as competition. Do the work on microcaps, and you can have an edge.
Alternatively, you can leave the work to a microcaps fund. Recently, the S&P Dow Jones Indices put out figures showing Australian mid and small cap managers are among the best in the world. 40% of these managers outperform their benchmark over a five-year period, and that increases to 49% over a 15-year period. Compare that to large cap equity managers with figures of 26% and 18% respectively.
- Adopt a long-term time horizon.
Individual and institutional investors trade frequently, which increases costs and often reduces performance. Holding stocks for five years or more will give you an automatic edge.
- Buy stocks with moats, as championed by Morningstar.
Companies with moats have more durable returns and, if purchased at the right price, can led to market-beating returns.
- Find niches.
It could be becoming an activist investor in tiny companies or specializing in a burgeoning sector like community living for retirees or looking outside of stocks to something such as distressed debt, which should have a nice future with interest rates rising off historic lows.