Ellis, who founded Greenwich Associates in 1972, has been vocal about his investing philosophy for decades: active investing is a loser’s game. As detailed in the new edition of his book, “Winning the Loser’s Game,” most investment professionals do not outperform when fees and risk are taken into account, making active investing unprofitable.
Ellis reveals how an average investor can get a leg up in this exclusive interview with Jenny Harrington, CEO of Gilman Hill Asset Management.
Jenny Harrington says: The first edition of “Winning the Loser’s Game,” written by Charley, was published in 1985. And you’ve most likely seen and written about a plethora of manias. So I’m curious to hear your thoughts on what we’ve seen this year. Have you ever seen anything like the manias and craziness at GameStop and AMC? And how do you beat the losers in 2021?
Charles Ellis: We’re all human. And we all do the same ridiculous, astute, astute, astute, astute, astute, astute, astute, astute, astute, astute, astute, astute, as We do a good job of mixing it up. So most of us have some habits that we believe we should break. I used to be a heavy smoker. I used to be a drinker. I don’t drink anymore, and I don’t smoke. And I have no plans to return. But it was a choice to do it and a choice to stop at the time. And in the investment world, we all do the same thing. We make mistakes all the time. And the key is to make as few minor errors as possible. And one way to do that is to refrain from participating in other people’s games, because, as you and I both know, there is a game going on. It’s very recreational and a lot of fun, and it can be quite exciting at times. And it will almost certainly be extremely rewarding for some. But, for most people, it will be something they would rather not talk about in 10 or 20 years.
Harrington: Do you believe that the investing rules have ever changed? And do you believe they can ever change?
Ellis: It depends on what you mean by “rules.” Regulations have evolved significantly. And the details of how to be successful have changed dramatically. But the fundamental concept of investing is laid out by John Burr Williams in his wonderful book, in which he states, “The value of an investment is the stream of future dividends that you will receive if you own a particular investment.” And you want to consider it in that light. And if you do, you will gain rational discipline in your thinking. That was true when he wrote his wonderful book in the 1920s, and it has been true in every decade since. And it will be true in every subsequent decade.
Is there a place for active investing, according to Harrington?
Ellis: I am a huge fan of active investing. You’d be surprised, but what I mean by active investing is actively determining who you are as an investor and actively determining what is the best investment program for you over time. Instead of wobbling around and drifting, actively think about your investment program every five years, maybe every ten years, and actively stay on track. As a result, I’m a big fan of this type of active investing. Now I recognize that there is a very small percentage of people who are involved in investing, are very good at it, and have discovered an area where they can be very successful as active investors. As you know from our previous conversations, I believe you are one of those people. Although it is not the only way to go, you tend to value in high dividend investing, which I believe makes a lot of long-term sense. But are there others who believe in doing deep dive research on individual companies of all sizes and picking the best ones to invest in if they aren’t working in the 1,000 largest companies and have extraordinary analyst skills to do deep dive research on individual companies? I believe that a small group of people with modest assets can do an excellent job and, over time, outperform the market averages that we all see. The part that excites me the most is that anyone, at any time, can outperform the market. And, seriously, I guarantee you’ll be in the top quartile. And, to be honest, I’d be willing to bet that if you index, hold on, and stick with it, you’ll be in the top half of the top quartile.
‘Pick them off one by one.’
Harrington: Charley, do you believe that a large influx of young investors who reject professional advice as a loser’s game will eventually turn the market back into a winner’s game? In other words, will there be more opportunities for professional ambassadors as inexperienced investors flood the market?
Ellis: Sure, I believe that whenever a group of innocent, hopeful, and ideally ambitious participants enters the market and does something they don’t really, really, really understand, professionals will sit on the sidelines and pick them off one by one.
Harrington: I believe that is a large part of what happened this year as well. It will be interesting to see how this unfolds.
Ellis: Yeah, and the nice thing is, it could have happened a lot. Those who witnessed it, on the other hand, will not speak of it or discuss it. Only those who lucked out and didn’t get nailed will have anything to say. And they’ll say it a lot, so you’ll get the impression, even if you’re just an outside observer, that there must have been a lot of successes out there.
Harrington: Your ten commandments are one of my favorite parts. And I was wondering if you think one of your ten commandments is the most important for people to remember?
Ellis: I do, indeed. It’d be the first option: save. Because almost everyone understands, at least conceptually, that you can’t invest what you haven’t saved. And the sooner you start saving and seeing it as a very positive way of creating and using value in your own life, the better. And the price. So, if you truly want to succeed, saving is the key.
Harrington: It’s funny because I work with a lot of clients on their asset allocations. And you discover that asset allocation plays a much smaller role in overall investment success than what you just said, which is saving — saving and avoiding crazy spending has a much larger impact on total portfolio return.
Ellis: Until you accumulate significant assets. And then, to be honest, I believe that what you’re doing with your portfolio does play a role. But you won’t be able to do so until you have a portfolio. And the only way to do so is to save money.
Market returns over the long term
Harrington: The stimulus limit is shifting in a new direction. But the stimulus that we’ve seen pumped into the economy and the market over the last year, and I guess you could even say since 2001, has been extraordinary. What do you believe the long-term and short-term consequences will be?
Ellis: Let me divide it into two parts, the first of which the Federal Reserve and the federal government should and are focusing on. They are very concerned about employment. And they are particularly concerned with people who are, quote, unquote, on the periphery of the labor force. And they would like to see those people well compensated for what they can accomplish if they go to work and stay at work. And as a country, that is exactly what we should be doing. There is also another group of people who are primarily investors. And, to be honest, they’ve gotten off incredibly easy. Because the Federal Reserve has been driving interest rates down to an unbelievably low level, as you can see if you look at his history. But they’ve done it on purpose for the sake of the economy and our society. It has inadvertently rewarded individuals who have owned bonds, stocks, houses, or apartment buildings. You just have to be careful who you’re looking at. And who are you working for?
Harrington: Right. One of my concerns is that with all of this stimulus, what will be the ultimate fallout? So there are the two parts you mentioned. Then there’s the long-term aspect. So my question is, if the historical market return has been in the 8 percent to 10% range due to stimulus, will that 8 percent to 10% range be lower in the future? Do you believe it is possible to maintain such a high annualized market return of 8% to 10% in the current environment? Or do you believe that the stimulus actually dampens the fallout?
Ellis: I believe you could make the case that it is possible. However, I believe it is highly improbable. And I can’t believe it’s possible for anything other than a short period of time.
Harrington: Then there’s the question of investor behavior. One of the things I’ve noticed is that on one of the investment committees that we work on together, we always talk about managing the emotions of the people whose portfolios you’re investing in. And one of the more difficult aspects of this is saying, “Oh, the market returns 8% to 10% over time, but one year you’re up 20%, one year you’re down 10%, and then you’re up 15%.” That is extremely difficult. What do we make of the pendulum’s tendency to swing too far? Why is it that the pendulum always swings too far? Is it necessary? Is that simply human nature?
Ellis: Well, it’s not a pendulum; it’s human behavior. And people have a tendency to take any good idea too far and turn it into a not-so-good idea, if not a bad idea. When we look back at the 1929 market crash, the market had gone up and up and up in ways that, in retrospect, if you saw the raw data and said, “This market is going to crash,” you would be correct. And you’d be correct. If you did the same thing with the change in interest rates in the 1970s, you would have predicted a terrible stock market crash.
Actually, if you factor in inflation and nominal losses, it was at least as bad as 1929 in the 1970s.
Harrington: I’m thinking about cryptocurrencies and how they’re similar to trading. I mean, it appears to me that they are similar to trading commodities. They are speculative in nature, based on the actions of others. Is it possible to frame them in terms of trading or investing? What are your thoughts on cryptocurrencies? What do you think of them as an investment right now?
Ellis: I assumed you were going to ask what you think of cryptocurrencies, as it’s a very exciting and imaginative field with some very, very smart people attempting to figure out how to do it, and then you put in the hooker at the end and as an investment. I can’t see it being a good investment right now for anyone who isn’t a profoundly experienced — and it’s difficult to become a very experienced — expert in what cryptocurrencies are all about. Or a psychiatrist pitted against the crowd’s idiots. I can understand either of those, but it’s not a game I want to play, and it’s not a game I’m going to play. Meanwhile, I believe there is a real possibility that the creative genius, particularly some of the people with advanced mathematical skills, will develop things that will be absolutely marvelous in terms of their ability to benefit their society as a whole.
Harrington: So, Charley, we discussed your ten commandments. Do you have an 11th commandment if you could do another one?
Ellis: Know yourself and the problem you’re attempting to solve. And the issue is unique to each individual.
Harrington: There are over 7,700 exchange-traded funds available. What is the best way to get started? Where do you begin?
Ellis: It’s similar to how you start eating ice cream. You begin by eating vanilla, and plain vanilla is either the total market index or the Standard and Poor’s 500 index, which represents a sizable portion of the total market. And, for God’s sake, don’t do anything you thought was an exciting, interesting ETF because it has leverage or does some unusual or specialized type of investing. Leave all of that for five or ten years later, when you’ve become an expert in the field and know everything, and dabble with it if you want. However, most of us who are serious about investing and are savvy enough to index still invest primarily in plain vanilla, which is still America’s most popular ice cream flavor.
What are the fundamental principles of investing, according to Harrington?
Ellis: It is necessary to save. Diversification is prudent and prudent. Indexing makes a lot of sense. And consistent perseverance over time makes perfect sense.
So it’s really not that complicated, Harrington. It simply appears to be complicated.
Ellis: Saving money is extremely important. And the great thing about saving is that it can be viewed as a way to win by amassing assets that you can then invest in and have work for you 24 hours a day, 365 days a year. And it’s a wonderful reality, this compounding that comes with investing. The second thing to do is to diversify as much as possible. And the simplest way to do so is to invest in an index fund that spans a wide range of stocks, such as the S&P 500, or the total market, which provides even more diversification. But diversification is extremely beneficial, partly because we never know what will be exciting and positive. And, in part, we don’t know what will be disappointing and negative. Diversification is the best way to avoid missing the first and getting too much of the second. Third, minimizing fees is a great idea because once you pay the fees, they are gone for good. And if you consider how you could accumulate unpaid fees, that does compound in a very, very nice way…. That brings us to the final point, which is that compounding is the great secret to investment success. My favorite investor is Warren Buffett. I’ve had a good friendship with him. And I think the world of what he’s done. But if Warren Buffett had the same talent but started as an investor after finishing business school and stopped when he retired at 65, he would only have a little more than $2 billion. And, as we all know, he has far more than $2 billion. And that’s because he spent a lot of time working for him and compounding, and compounding is a tremendous power. And the majority of the impact of compounding occurs in the last 10% of whatever time period you’re looking at. So get started early, stay as long as you can, and let compounding work for you.
Regarding Buffett and compounding
Harrington: One of my favorite quotes is from Albert Einstein, who said, “Compounding is the world’s eighth wonder.” I also believe that one of the things that you and I are well-versed in as professional investors, but I’m not sure if new investors are, is the 7-10 rule, which states that if something grows at 7% per year, it will double every ten years. And I believe it is critical for people to consider this when putting everything they have been given to work and deciding how to allocate their portfolio. If you can only get a 7% return on your portfolio in ten years, it will double. It will double again in ten years. Compounding is truly amazing.
Ellis: It’ll double again, and again, and again. It’s absolutely stunning.
Harrington: Charley, one of the things you mention repeatedly in your book is benign neglect. How far can a person allow that to go before they need to be proactive with their portfolio? Where do you draw the line between needing to be active and a participant and allowing benign neglect to work for you? I always think that when people keep their finger in their portfolio, they’re just messing things up. They should take a step back and let it go. So, where do you draw the line between benign neglect and proactive management?
Ellis: Well, most of us make far too many investment decisions. And those who make decisions on each individual security in a portfolio are doing far too much. If you take a typical mutual fund with a 40% turnover and 40% changing their minds, my Lord, what does that make for the average length of time they own securities in the portfolio? It’s been a little over two years, which isn’t a very long time for compounding to really get in there and work on it. Then there’s the cost of making decisions, which is known as transaction costs. Then there are taxes. You only pay taxes when you make a profit. When you put all of those things together, we all make mistakes more often than not when we make a decision. The third dimension is to recognize that everyone else reads the same newspapers and magazines, watches the same television shows, and reads the same books. We all know a lot of the same things and have a lot of the same details. And we read the news about politics, international relations, and bad relationships, good relationships, bad politics, and good politics. So, in our knowledge base, we’re much more equal to each other than we realize. And if we constantly react to that sort of thing, we’ll be acting in ways that are congruent with each other, and it’s very difficult to beat someone who is doing the same thing you’re doing when you’re doing the same thing they’re doing. As a result, benign neglect assists us in reducing the number of errors we make. I believe that being a parent of adolescent children provides the best training for investing because every parent of adolescent children realizes, at some point or another, that less is more. Fewer instructions are more effective. Fewer decisions are more effective. And the kids will grow up to be nice young people, and you will be very proud of them after they leave home.