The Loser’s Game

What kind of competitor are you?

Photo: Alexas Photos. Source: Pixabay. CC BY-SA 2.0

When we watch sports, we see two types of games – winner’s games, and loser’s games. Winner’s games are exciting. They’re like the Super Bowl: lots of fast-moving action, dramatic decisions, incredible athleticism. The winners train, prepare, concentrate, and execute. They’re like Raphael Nadal or Mikaela Shiffrin, pushing the boundaries of personal performance.

But most of us don’t compete that way. We play a “loser’s game.” The way to win, for us, is not to lose. If we’re playing tennis, we just have to get the ball back over the net, in-bounds. If we’re skiing, we just need to get down the hill without falling. Loser’s games are slow, steady, and boring. You win by staying in the game long enough to exploit the other players’ mistakes.

It’s a similar story with investing. The only way to beat the market, after adjusting for market risk, is to discover and exploit other investors’ mistakes. This can be done by searching for and finding “winners” – the stocks that are destined for glory, the Cinderella stories that no one sees until everyone sees them. That’s the winner’s game of stock-picking. It’s challenging and exciting and if you’re really successful you can get on CNBC or Cramer and become a big celebrity.

But there’s another way.

The other way is to play a loser’s game. To invest this way, we need to identify the losers in a portfolio and avoid owning them. It isn’t dramatic. Instead of picking stocks, we “un-pick” the losers. But it can be quite effective.

Over time, the vast majority of companies merely tread water. A few years ago, a firm looked at the broad market over a long time-span. They found that almost 40% of stocks had negative returns over their lifetime, and almost 2/3rds of stocks underperformed their index. The bulk of a stock index performance is driven by the top 5% of companies – a “fat tail” of a few over-achievers, like Apple, Microsoft, or Amazon. Last year, I updated their research and found the same result: most companies don’t add value; just a few stand out.

Source: Blackstar Funds

Amazingly, if you held all the equities at the beginning of the period and rank their returns from the least profitable to the most profitable, your collective return was *zero* if you missed the 25% most profitable stocks. That’s why winning the winner’s game is so hard! There are just a few firms that defy the odds and come to dominate their markets. This makes some intuitive sense. Developing a winning product and delivering it efficiently and effectively in a competitive marketplace is hard work.

By contrast, it’s a lot easier to pick losers. To start with, there are a lot more of them. Just a random assortment of stocks is likely to have a lot of losers. And with the widespread adoption of indexing, it’s even easier now. Some observers call this the “Vanguard Effect.”

Source: Pixabay

Every day, a great river of liquidity flows into index funds, through 401(k) elections, target date funds, ETFs, and so on. The growth of passive investing has been phenomenal. The late Jack Bogle was astounded by the success of his innovation – a mutual fund that invests in low-cost basket of stock weighted by their market capitalization. But that very success creates a problem.

Because every week this wall of money hits the market with the simplest formula possible: “When I contribute to my 401(k), buy.” The plan has no discretion, no price sensitivity, it proceeds on autopilot. When I contribute, buy. Over 50 million people invest billions of dollars each week, lifting the value of every stock in the index. Every stock – both winners and losers, both the Amazons and AOLs. All that’s necessary, to win the loser’s game, is to avoid the losers.

And losers are pretty similar, when you look under the hood: they shed employees, they don’t invest in R&D, they use accounting gimmicks to boost earnings, they don’t pay their shareholders. Most importantly, they lose money – or at least, they don’t make as much as their peers. It’s possible for inspired management to turn things around. But, on average, that’s not all that common. The race may not be to the swift or the battle to the strong, but that’s the way to bet. Losers usually just keep losing.

By owning every company in an index, in the proportion that the index holds them, and cutting out the “losers,” it’s possible to win the loser’s game. It may not be as exciting as picking the next Tesla or meme-stock. But to be honest, the most profitable investment strategies are often the most boring ones.