The Reason Why You Need to Invest Passively

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When investing legends have been suggesting something for decades, you couldn’t go wrong in heeding their advice and follow the path of passive investing.

When investing legends have been suggesting something for decades, you couldn’t go wrong in heeding their advice and follow the path of passive investing.

There are two games of tennis: professional tennis and amateur tennis. In the former, players try to win points by playing immaculate shots with accuracy and complemented with deception and strategy to try to outwit and outplay the opponent.

In contrast, in amateur tennis, rather than winning points, players tend to lose points by fouling or making unforced errors. In this type, you’d win automatically merely by making fewer mistakes than the opponent and keeping it simple.

 
 

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This was the brilliant analogy used by Charles D. Ellis, founder of Greenwich Associates, in his groundbreaking and famous article, The Loser’s Game which was published in 1975.

Although the tennis example was borrowed from Dr. Simon Ramo, the analogy he drew from this example into the investment business is what changed the way passive investing was looked upon at by finance professionals.

Professional tennis was dubbed as ‘The Winner’s Game’ while amateur tennis was dubbed as ‘The Loser’s Game’, which was also the title of the article published by Mr. Ellis.  

To quantify his tennis example, he cited Dr. Ramon’s data in which it was discovered that in professional tennis, 80% of the points are won by players but in amateur tennis, 80% of the points are lost by making errors not forced upon by the opponent.

After citing enough examples for both the winner’s and the loser’s games, he drew his analogy: Investing is a loser’s game.

Investing is a Loser’s Game

He contended that investing was a winner’s game a few decades earlier wherein professional money managers and institutional investors could ‘outwit’ and ‘outplay’ the market by making informed and intelligent investment decisions. These investment decisions were successful since the share of the retail investors in total market transactions was above 70% while the ‘professional’ share was only 30%. In short, retail investors, who were amateurs and didn’t know how to play the game with intelligence, strategy, and prudence, dominated the market. There was a huge scope for a professional to come in and exploit the amateurs by just ‘standing and delivering’.

These professionals made a huge amount of money in those times. Big money naturally attracted other professionals into the game. Even these new professionals earned a lot of money. Since these professionals were earning huge returns on their investments, a premise was formed: professional money managers can outperform the market. This premise led to huge cash flows to these managers in terms of managing them.

These flows continued as the money managers continued to earn big bucks till the middle 60s. During that time, the share of the professionals in the market activities increased from 30% to a mammoth 70%. They, the professionals, represented the market now.

It’s difficult to outwit and outplay the professionals. When they became the market, it turned difficult to beat the market. Data in the article showed how the professionals lagged the market on a consistent basis from 1965 to 1970.

The reason for this was that in a desperate struggle to beat the market, these professionals started making more trades and trying new things which ultimately led to a significant increase in the costs but little to no gain in their results. So, while the market was going at its own pace, to try and win the game, these professionals were losing a lot by incurring more costs – making more unforced errors.

Thus, The Winner’s Game had converted into The Loser’s Game and Mr. Ellis contended that if you can’t beat the market, you should join it.

As a way out, he suggested investing in passive index funds which have the lowest costs to manage and operate.

Why You Should Invest Passively

Even today, the maximum of the money managers can’t beat the market. Great investors like Benjamin Graham who was the guru of Warren Buffet and Buffet himself have reiterated the concept of low-cost index funds countless times even though they both have consistently beaten the market through decades. While Graham did that when investing was a winner’s game, Buffet is doing it when investing is a loser’s game.

When investing legends have been suggesting something for decades, you couldn’t go wrong in heeding their advice and follow the path of passive investing unless you could devote considerable time to making informed investment decisions. If you aren’t a professional who is capable of reading businesses and evaluating them, you should consider investing a consistent amount each month in these low-cost index funds and watch your wealth grow over time.

Guest Post by Piyush Shah

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