Charley Ellis wrote a book years ago called Winning the Losers Game, essentially the main idea is that to win in investing we should focus on avoiding the losers. His idea was based on a book about professional tennis being a winners game, you win tennis by hitting more winners than your opponent, therefore you should go after the winners. However amateurs win at tennis by making less mistakes than their opponent. Investing for amateurs should be the same, to try and avoid mistakes and that is why Ellis was a big advocate of index investing.
A lot of fund managers as well as professional investors I know want to win the game by playing like professional tennis players, hitting a lot of winners. They want to be in the top quartile of performance rankings each year. Even better it would be nice to be in the top 5%. It’s great for your ego and it also helps the hip pocket as money tends to flow your way.
But often when you aim to be in the right hand tail and hitting a lot of winners, chances are you will often end up in the left hand tail as you will hit a lot of unforced errors. Very often managers will be a great performer for a year or two and then crawl back to middle of the road and then struggle for the next few years.
The most consistent investors who have longevity in investing try and focus on avoiding the left hand tail. They take the ones in the middle and hopefully catch some returns slightly right of the middle.
There is a great anecdote Howard Marks retells when he was speaking about this to a pension fund manager. This fund manager said that over a 14 year period his annual performance in his best year was at the 27th percentile of peer manager performance, and at his worse year was the 47th percentile for performance. See the highlighted section below, on a yearly basis this manager never exceeded this band annually for 14 years.
He did not shoot the lights out and try and be in the top 5% of manager performance, which meant that he never fell in the bottom 5%. He quietly went about slightly above average performance for a long period of time.
Where did he finish in the percentile rankings after measuring over the full 14 year period? He was in the top 4% of all managers, see the little strip in the chart below.
This to me sums up why so many managers and investors miss the point on peer performance table rankings. Not chasing performance and not wanting to be in the top quartile is hard. Envy is a wagon that plenty of people hitch themselves to. Nobody wants to be just a little bit better than average, it’s not good for our ego.
Now imagine as a manager you pitched to a prospective client by saying we just want to be a little better than average and over time this should work out really well. Compare that to the hot manager who for the last 12 months has been top of the pops. Chances are they have captured some outlier, a lot of luck was involved that was passed off as skill. Where do you think the money will be allocated? Odds are it won’t be with the boring manager who has never been in the top quartile of performance.
In a bull market it is bloody hard to tune out the cries from the bleachers and not feel like you are missing out on something as people shoot the lights out. However I have paid my tuition fee once and I am not going to pay it again. I am happy to be slightly better than average and let other people chase the glory in the top quartile.
The thing is, if you haven’t paid your tuition fee then you will think what I am saying is garbage and I just don’t get it and I am missing out on some wonderful gains if you just let your standards slip. And that is OK, I am cool with not getting it.