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Imagine playing a game where the best strategy is not to try to win, but rather, to try not to lose. This might sound ridiculous the first time you hear it, but in the real world this is often the optimal tactic to follow to ensure success. Sometimes, if you recognize the type of game you are playing correctly, a defensive strategy, keyed to avoiding errors, often vastly outperforms an aggressive strategy, focused on trying to win the game. The key to being successful with this approach is to recognize the type of game being played early on and then use the strategy that maximizes the chances of being successful at playing it. Charles Ellis, the noted investor, lecturer and past chairman of the Chartered Financial Analysts Institute, wrote one of the best books ever on investment strategy. He called it Winning the Loser’s Game. In it, he demonstrates how the two basic ways that we play games are related to investing strategy. By simply recognizing the type of game you are playing when you invest in the markets, you have a tremendous advantage in achieving financial success. According to Ellis, games can be segregated into two basic types. There are winner’s games and there are loser’s games. Winner’s games are ones like football or lacrosse, where the winner is often the team who takes an aggressive action at the right time. They are games where you can take proactive actions that can allow you to win. Loser’s games, on the other hand, are games in which there is no affirmative action a player can take to affect a win. These games become ones which you don’t try to win but ones in which you try to prevent a loss. You have to recognize the type of game you are playing in order to adopt the correct strategy for success. His contention is that when you play amateur sports, or are an amateur investor, you aren’t playing a game in which aggressive actions can help you win. You first have to recognize that you are playing a loser’s game. Strategy dictates that the way to win these games is to be the player with the least amount of unforced errors. Amateur tennis is an example Ellis uses as a loser’s game. It is one that you can’t win by your own actions but that is yours to lose by making mistakes. Ellis got his idea from a book called Extraordinary Tennis for the Ordinary Player by Simon Ramo. In this book, Ramo demonstrates that in order to win at amateur tennis, players need to play a game designed not to lose. The goal of a successful player should be to make the fewest number of mistakes. Ramo did a careful statistical analysis of matches and found out that, by overwhelming numbers, the amateur players who consistently made the fewest number of mistakes came out as winners. The players who always charged the net, tried the difficult passing shots, and always went for the kill made vastly more errors. This aggressive approach resulted in a much lower overall win rate than simply waiting for the other player to make a mistake. Two other examples of common loser’s games are tic-tac-toe and amateur golf. In tic-tac-toe, even a young child soon learns that the only way to win is dependent upon the other person making a mistake. There is no strategy you can employ, or aggressive move you can make, that will improve your chances of winning the game. The only strategy that will give you a fighting chance is not to make a mistake while patiently waiting for your opponent to make an error. Similarly, in amateur golf the most successful players are the ones who play within themselves and don’t make a lot of errors. If you are an eight-handicap golfer, you win by consistently playing to your handicap while avoiding any errors that cause you to needlessly lose strokes. Your goal is to play within yourself and take advantage of your strengths while avoiding taking chances that have low probability of success. This is often the case when you are faced with the decision of laying up a shot or trying to make a shot over a hazard that you are not sure you can make. When you go for the pin, over a long water hazard with a low-probability shot, it might make you feel like Tiger Woods if you make it. But, generally, it is not how a great amateur golfer consistently wins matches. When you take unnecessary risks the cost of a making a poor shot can be so high that you might never be able to recover from it. The player who takes what is given to him, and patiently waits for the competition to make a mistake, is usually the one who finishes near the top. This concept of the loser’s game can also be applied to investing. Over the last several decades playing the market from the standpoint of a winner’s game has become increasingly difficult. The percentage of investors in different asset classes that successfully beat the averages has become lower and lower. Since the average investor does worse than the index that they are trying to beat, the markets have started to resemble a loser’s game, where not trying to beat the average has an advantage. Several decades ago, investing was a game played mostly by individuals. They were playing a winner’s game. Now that has changed. The markets are now dominated by large institutions with similar access to information and similar information-processing ability. It has become increasingly difficult beat the market and it now resembles a loser’s game. The markets have changed from ones where people were rewarded in taking an effort to try to beat the market to one where the best strategy is to try not to lose. So, what are the implications of playing a loser’s game for managing your portfolio? First of all, you can’t beat the market unless you are extremely good or lucky. The competition is just too tough. The major pension plans, brokerage firms, mutual funds and hedge fund companies have hundreds of thousands of employees, all highly motivated, highly educated and ultra aggressive, looking for any opportunities to earn a profit. Do you really believe that an average individual, no matter how diligent and intelligent, can regularly beat this army of experts? It’s like taking your company’s softball team to play against the Philadelphia Phillies. You might get lucky and win a game now and then but the long run outlook vastly favors the professionals. What we do know for a fact is that the capital markets, over long periods of time, reward investors who are patient enough to be invested in them. The return to investors is their reward for taking risk. That return is available to all who participate in the markets. What you don’t want to do is give that return away by trying to beat that market unnecessarily. When you are investing for your future, your number one priority should be to avoid mistakes. If you need a certain amount of assets to fund your retirement, or provide for a child’s education, making an unforced error might be a mistake from which you can never recover. Capital markets have enough risk for all of us without adding more by unnecessarily taking chances. Ellis put it very succinctly when he said, “The great secret of success in investing is to avoid serious losses.” Does this mean that you should not make any efforts to maximize your investment experience? Absolutely not. What you should focus on is what you can actively control. To do that, you need to have a written investment policy that directs your strategy. This policy lays out your goals, your time frame, your anticipated savings and tax policy, all of the factors that go into your investment plan. The purpose of this policy is to force you to think about how you will behave towards your investments in times of stress. In other words, policy prevents panic. It keeps you from letting short-term fluctuations in the market place control over your long-term investment goals. Ellis believes that average investors are best advised not to try to win at the stock market game. For most investors, it is a loser’s game. This being the case what they need to do is minimize errors. You improve your chances of reducing errors by having a written game plan before you start. Don’t over trade, don’t take on too much risk, don’t pay too many costs, don’t try to time markets, and don’t chase hot tips. Since you can’t win at this loser’s game, your best chance for success comes from making the fewest amount mistakes. WILLIAM Z. SUPLEE IV is the president of Structured Asset Management Inc., a financial planning and investment advisory firm located in Paoli, Pa. He may be reached at 610-648-0700 or [email protected].

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