Investing legend Charley Ellis, a treasured member of the Rebalance Investment Committee, has spent decades challenging assumptions. His seminal paper on investment strategy, first published in 1975, later became the bestseller Winning the Loser’s Game, now entering its seventh printing.
In that paper and later in the book, Charley proposes the disarmingly simple idea that investors do themselves the most harm by trading and that truly winning at investing results from just avoiding mistakes. Along the way, he founded Greenwich Associates, an international consultancy that advises institutional investors, foundations and government organizations in more than 130 countries. He teaches at Yale and Harvard, chaired the Yale University Endowment investment committee and served on the board of Vanguard Group.
His latest book is The Index Revolution: Why Investors Should Join It Now. The culmination of five decades and counting of frontline professional investing experience, Charley wrote the book, he says, because he feels the strong urge at “make a difference to other people” at the peak of what has been long and successful professional life. As his longtime friend John Bogle, the founder of Vanguard, says in praising the book: “Indexing is the only strategy that effectively guarantees investors will earn their fair share of whatever returns are provided by the stock and bond markets.”
I recently spoke to Charley Ellis about the book, his ideas about investing in stocks and bonds now, and what he tells his own children about the investing life, here is part one of our talk.
You counsel investors to do less, rather than more, including the use of index funds over picking stocks. Is boring the secret to better investments?
Well, that’s like saying boring is the secret to good driving. Good driving requires paying attention to the other vehicles on the road, paying attention to the speed limits, paying attention to your gas meter, watching what your speed is and how much space is between you and the other cars. Now, in a way, that’s pretty boring stuff.
On the other hand, all of us remember that first week our parents took us out on a highway and said “Why don’t you give it a try?” We thought there were way too many cars, they were going too fast, and they were all in different positions and they kept changing their positions. It was terrifying and difficult and challenging. It gradually becomes something that you can do on a more regular basis.
But the secret to driving is avoiding mistakes. Once you learn that, the rest of it all comes together. It’s just avoiding the difficulties so, in a way, you could argue that if you avoid dumb moves and mistakes in investing it will work out fine, and I think that’s perfectly sensible. What has happened, which most people find very difficult to see, is the constantly changing nature of the markets.
When did things change for you, that moment when you knew there was just no turning back and that index investing was here to stay?
This is one of those things that has been a steady migration of change. I’ll give you a couple of examples that you’ll see in my book, The Index Revolution.
Fifty years ago, only 10% of trading at the most on New York Stock Exchange was done by professional investors, and they were not the greatest, fanciest professional investors. It was insurance companies in Hartford, Connecticut; regional banks with their trust departments all over the country; a few mutual funds in Boston and a few mutual funds in New York, one in Minneapolis. There wasn’t an awful lot going on. Ninety percent of trading was done by individuals, and those individuals typically, on average, did a trade very year or two and it was usually because they got a bonus or an inheritance, so they bought some stock. What stock did they buy? Half of the time it was AT&T and half the time it was something else.
There were a few people that did trading on a regular basis, but they were very, very small. Most people bought stocks when they had surplus money and sold stocks when their kids went off to college or they wanted to buy a home or something like that. They were outside the market. They were not paying any attention to comparative prices. They didn’t know very much and nobody was telling them very much.
Well, if you look today it’s not 9% that’s institutional, it’s 99% that’s institutional, and those institutions are in the market all day, every day making comparative prices of one stock for another and another and another and, therefore, trying to find any kind of an imperfection in price that they could capitalize on. Because you can only find a mistake if it is made by one of the other professionals, it’s getting harder and harder and harder.
People seem to be convinced of the opposite, that there are mistakes upon which a savvy investor can capitalize. Why have things changed so much?
It used to be, back in the ’60s, the mistakes were made by individuals and they would last for months. I remember once watching DuPont drop 50% in price for reasons that were clearly predictable. It was shooting fish in a barrel, really easy. Now you can only buy from or sell to other professionals. Secondly, they all have access to the same information because everybody has the Internet and that means worldwide information is yours instantaneously all of the time.
Today, because of federal regulation, everybody gets company information simultaneously and because of Internet distribution it’s available to everybody wherever they are and whatever form they like, instantaneously. That’s a hell of a change, but it came gradually. And the volume that has gone from mostly retail to mostly institutional. Changed gradually. But they have all been changing pretty much consistently in the same direction, making it harder and harder and harder.
It’s still, I think, possible for brilliant mathematicians to find ways to outmaneuver the market, and I do believe if you had a small group of people who are hugely talented and very diligent in their research and they were working on 10- and 15-year time horizon investments that they could do quite well.
I’m all for that, but it’s a smaller and smaller fraction of the people who invest and most of us should recognize that when we invest, we invest in large mutual funds that are obliged to go to the large-cap stocks that are widely followed, and that there aren’t very many surprises. It’s not a place where one mutual fund could beat another.
So the myth of beating the market is truly a myth, at least for the vast majority of retirement investors?
In fact, now we’re able to see that if you add back in the mutual funds that disappeared or dropped — because they were such bad performers they weren’t selling any longer, those funds that get merged into other funds or just terminated — if you add those guys back, the underperformance is over 80%, that is, 80% of mutual funds fall short of the target that they had in mind to beat.
One other change is really important. When I first got into the field 50 years ago there might have been 5,000 people who were involved in active investment management. There are now at least 500,000 and I would bet closer to a million people one way or another directly involved in trying to figure out errors, mistakes in pricing made by any other investor, who will always have to be one of those other professional, full-time investors. That’s not an easy place to make any money.
Investing seems to be a zero-sum game: For one investor to generate alpha, a return above the stock market index, then another investor has to experience an equally negative return. It has to come from somewhere, right?
That is very important, but remember because of the fees and the costs involved it’s not a zero-sum game, it’s a negative-sum game.
How important is the negative sum? Go back 20 years and people were seeing returns in the market of 15%. One-fifteenth is not all that bad a fee. But if you are looking forward, people are seeing 7% returns. One percent of assets is 15% of returns. Well, if I can get those returns for one tenth of 1% from index funds, what’s the case for active investing?
Not a very good case. You pay 10 times as much and, on average, you get significantly less return, but unfortunately most people aren’t thinking about it quite that way.
If most investors decide to index, you’re only left with the smart money in the active space. Doesn’t it just get harder for those that remain?
Well, you can argue that, and I think it’s plausible that the first people to give up will be the people who have the least capability, but it actually isn’t working out that way. People who are stopping active turn out to be almost equally competent at least to the people that I have been exposed to.
The reason people go to indexing is that they observe the reality and say the process that I used to follow is no longer working and there is no reason for me to anticipate it is going to come back to working again. Therefore, I’m going to stop doing what I used to do.