Winning the loser's game

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McGraw-Hill Professional

(MoneyWatch) There have been only a few books that have shaped my investment philosophy, and one of them has just been revised and released -- the sixth edition of Charles D. Ellis' "Winning the Losers Game," published by McGraw-Hill Professional. Like with other classics that remain timely, Ellis explained to me that the Ten Commandments of Investing are more valuable now than ever before.

As a tennis player, I can relate to Ellis' loser's game analogy in that I have rarely been beaten by an opponent, yet I lose quite often. That's because, at my club level of play, I typically beat myself with really dumb shots that I repeat with a frequency I can't begin to explain. Most investors do much the same in investing and end up beating themselves by making dumb choices. Here's my take on how the book's Ten Commandments will help you win the all-important game of financial freedom.

1. Save. If you don't live below your means, financial freedom is not within reach.

2. Don't speculate. As a financial planner, I'm often asked what I think of a particular stock or what the market will do next month. I respond that I'm an investor not a speculator.

3. Don't invest primarily for tax reasons. When I advise clients to pay off their mortgage, they often resist out of concern that they will have to pay more in taxes. I tell them that they will actually make more after taxes, which is a far more important goal.

4. Don't think of your home as an investment. Yes, real estate can go down in value and has high carrying costs such as taxes and maintenance. Still, the home is the one thing that you can enjoy that also appreciates in the long run.

5. Don't do commodities. Commodities typically don't appreciate in real terms, and individuals often buy after surges and sell after plunges.

6. Understand the role of brokers and mutual fund sales people. They are really nice people whose job it is to have you take all of the risk so that their firm can make most of the money.

7. Don't invest in new or interesting investments. Wall Street has an endless source of investments that look too good to be true and, in fact, are.

8. Don't invest in bonds primarily for safety. Ellis notes that bonds can fluctuate nearly as much as stocks. Here I've got to respectfully disagree with Ellis in that high-quality bonds and bond funds are much more stable than stocks and really do serve as a portfolio shock absorber.

9. Write down your goals and investment policy and stick to it. As I tell clients, though picking an asset allocation policy is important, sticking to it is even more critical.

10. Distrust your feelings. Human instinct is usually dead wrong. Our feelings are reactionary, a response to whatever is going on at the time. Thus any decision made with such a mindset tends to be emotional and shortsighted. This is the sort of mindset that compels us to join the buy-high, sell-low herd, depending on whatever the markets feel like doing that day, and is sure to chip away at your real return.

I love Ellis' Ten Commandments, but being the most argumentative person on the planet, I challenged him on his view on bonds. Ellis explained that interest rates were at historic lows and that the government's planned end to quantitative easing will likely lead to increasing rates. This, of course, will be bad for bonds and bond funds.

I argue, however, that it's real after-tax rates that matter most and, at a 28 percent tax rate, the 10-year Treasury yield was about four percentage points lower in 1980 than today. I think markets understand that the government won't buy back our own bonds forever. I also think sticking with a consistent fixed-income allocation is more important today than ever, now that stocks are near an all-time high.

I spoke to Ellis and asked him what he felt was different today than when he wrote the predecessor article about the loser's game in 1972 in the Financial Analyst's Journal. Ellis explained that, years ago, individual investors represented the vast majority of stock trades, and it was relatively easy for the professional to beat individual investors. Today, institutions represent over 95 percent of all trades, and paying one professional to beat other professionals is a loser's game.

Ellis notes that buying low-cost index funds and rebalancing is one sure way of winning the investment game. According to my calculations, it will get you to the top 1 percent of all investors over a 25-year period.

As I said, Winning the Loser's Game is one of those timeless investing classics that is even more valuable today than when it was first published. Reading it again, in the context of two 50 percent-plus stock market crashes since 1999, will demonstrates the wisdom of Ellis' advice.

I will never be in the top one percentile of tennis players (or even close), as I can't seem to stop repeating the same mistakes. But if I follow Ellis' Ten Commandments, at least I'm virtually assured to be in the top one percentile of players in the investing game.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.