How to Win at Investing

The Key to Winning is to Play the Right Game

Imagine you decide, in an effort to improve your overall health and wellness, that it is time to start running.  You go out on some training runs and then decide to join a local 5k.  You run this first race in 30 minutes flat.  How do you decide if that is good or not?  Did that meet your expectations?  How did you place according to your age group?  What if you go out to the next race and your time is 31 minutes?  Is that good?  Maybe that second race included a lot more hills and the average time of all runners was 33 minutes.  How does that change the perception of how you did?

In investing, most people attribute winning to whether or not you beat ‘the market’.  If ‘the market’ returned 10%, a 12% gain is considered a win, and an 8% gain is considered a loss.  But what does ‘the market’ consist of?

The returns of ‘the market’ can be thought of as just the average return of all the market participants.  This includes the largest hedge funds, the ‘mom and pop’ investors in retirement, university endowments, and pension plans.  Each of these groups have different goals and objectives for their investment portfolios.  These billions of dollars buying and selling stocks and bonds is what determines the market returns.  So, if the market return is the average of all of them, the ones who perform better than the market must be equal in magnitude to those that underperform.

A great podcast I listen to with some regularity is Invest Like the Best hosted by Patrick O’Shaughnessy.  Patrick is the CEO of O’Shaughnessy Asset Management and an astute market observer.  One thing he likes to say is that he sometimes wishes he called the podcast “This is who you are up against” because he interviews some of the smartest people in the world of investing.  And, if you are trying to beat the market, but the market consists of these super-geniuses, how does the average investor think they will get an edge?  This is the poker table analogy.

A Crazy Game of Poker

If 10 people sit around a poker table, the worst players will essentially subsidize the really good players.  In order for someone to win, someone has to lose.  The average players can break even and trade a few chips amongst themselves and have a good time.  The ‘market’ in the case of the poker table is measured as the net gain in chips at the poker table.  Since no one is creating chips and none are getting added to the table, the market performance is flat, or 0.00%.  So, if anyone is going to gain chips, they need to be taking from other people at the table.

If you wanted to make money at poker and you saw some of the best poker players in the world, Daniel Negranu, Phil Ivey, and Annie Duke, sitting at a table, you would likely go look for another table.  It would be very hard for you to win that game.

This analogy is used often in investing.  The really great investors like Warren Buffett, Ray Dalio, and David Tepper, do better at the expense of the suckers at the table – the ‘mom and pop’ investors who don’t know any better.

What Game are You Really Playing?

Let’s go back to the running analogy.  It is a lot less clear what one considers winning in running.  My first race, I made it across the finish line without dying – that was a win in my book.  Just like in the investing world, each of the runners lined up at the starting line have different goals and objectives for the race.  The crazy thin and wiry guys and gals at the front may, in fact, be looking to beat everyone else.  Some people at the back of the pack are just looking to get a decent workout in.  Some runners may want to win their age division, and others want to set a new PR.  Winning represents different things to each of them.

In investing it should work the same way.  The reality is that most people shouldn’t worry about beating the market.  Instead, winning in investing should be dependent on your personal and financial goals.  Are your odds of retiring with the lifestyle you want greater today than they were yesterday?  If so, the movement of the market (and thereby, the other market participants) shouldn’t worry you at all.

Financial securities, like stocks and bonds, should be viewed as tools to reach financial goals.  Some tools add capital appreciation, some provide income, and others act as counterweights to help smooth results (diversification).  The performance of a broad-based market index should not determine whether or not the assembled tools perform the task they are assigned.

Now I know what some of the investment folks out there will say.

“Keith, we all know about adjusting the allocation of investments depending on someone’s risk profile, but don’t you still measure how the stocks do against the stock market, and how the bonds do against the bond market?  This talk of not caring about beating the market sounds like a cop-out!”

To which I reply,

“Of course, I look at performance against a market index for client portfolios all the time.  But guess what – they don’t always beat the market, and I am perfectly fine with that.  I am saying that performance against the market index should not be the determinant of winning or losing.”

Maximizing the probability of meeting financial goals should be the primary indicator of success for most people.  This requires a keen awareness of risk and being able to asses what could happen to your investments.  If avoiding certain risks means that your return is less than the market, you should be ok with that.  In fact, chasing market beating returns is what gets many people into trouble.

Keys to Winning the Game

How should one go about winning the investment game?

  1. Identify what it is you are trying to accomplish with a given pool of assets.
  2. Assemble an appropriate set of tools (growth stocks, income stocks, bonds, etc…) to best achieve that goal.
  3. Mark progress towards that goal including the probability of success and the probability of failure. This includes a keen understanding of risk of loss.
  4. Realize that assembling the right tools to best achieve your goal may mean that your performance differs from that of a market benchmark.

This is the part where you say “Keith, that’s a real great theory you have there but what is the practical application.”

And then, before I go any further I feel compelled to reiterate the disclaimer (Nothing in this post should be construed as financial advice.  Before making an investment in any financial security, please consult your financial advisor.  If that person happens to me, I look forward to hearing from you.  Nothing in this post is design to treat, cure, or prevent any diseases….wait, I’m getting off track…)

Practically Speaking

The longer your time horizon, the more money you should have allocated to higher risk growth stocks.  For shorter time horizons you should be using less risky and more income generating securities.

Remember that instead of trying to beat the market, it often makes sense to just be the market in the form of investing in low cost passive index funds.  These funds just give you the average return of all the market participants listed above and do so at a very low cost.  Most people lose the investment game because they blow themselves up in search of higher returns.

When looking at risk, just remember that the stock market went down 50%, from top to bottom, during the financial crisis.  You can use that as a very quick rule of thumb to stress test your portfolio.  If 80% of your portfolio is in stocks, and those stocks can decline by 50%, your portfolio would take a hit of 40%.  Would your financial goals still be on track after that?  If you are 30 and starting to save for retirement, the answer is probably yes.  If you are 60 and looking at retiring soon, the answer will likely be no.  This is the difference between winning and losing.

Looking for advice is a great strategy if you are not willing or able to manage investments on your own.  A great financial advisor will help you identify your goals and make sure your investments are on track to meet them.  Just remember that paying over 1% of the assets to be managed is too high.  Paying commissions to advisors is a terrible arrangement.  Finally, make sure that the advisor is willing to act as a fiduciary (they are willing to hold themselves legally responsible to act in your best interest).

In Closing

While I love Patrick O’Shaugnessy’s work and his podcast, the “this is who you’re up against” message is not applicable to most investors, (I do still highly recommend people tune in.)  You can still achieve success no matter what algorithms and models the next generation of super-investors are using.  The world of investing is much more like a 5k than a game of poker.  You should not worry about what other investors are doing.  You should care about your own results and focus on achieving your goals.

A friend of mine holds a handful of large, well-known stocks that pay good dividends.  He says he doesn’t look at the price fluctuation except for when that price goes down.  If they pay the same dollar amount of dividends that means their dividend yields go higher so he may buy more.  All he is interested in is the income stream.  Do you think he cares what the market does?  He is winning if the income keeps rolling in and supports his growing book collection.

When it comes to investing winning is different for everyone.  As long as you set a clear goal, you can win the game of investing no matter what anyone else is doing.

Until next time….

“Winning is like shaving – you do it every day or you wind up looking like a bum.” Jack Kemp

and of course “Winning, duh.” Charlie Sheen