The Sound Mind Investing newsletter offers two primary investing strategies, featuring two very different approaches. Fund Upgrading is an "actively managed" strategy, where we make investing decisions every month in our effort to earn better returns than the market obtains. By contrast, our Just-the-Basics strategy makes no effort to figure out how to beat the market. Its goal is simply to mimic the market closely and accept whatever returns the market earns.
In recent years we've written often about Upgrading but only occasionally about Just-the-Basics. The main reason for this emphasis is that we believe Upgrading will produce better returns over time. That expectation of superior returns has been realized each of the past six years, during which Upgraders have earned cumulative returns ten times larger than those of the overall market, and four times larger than those of Just-the-Basics. (See SMI's Upgrading Portfolios Expand Their Lead Over the Market.)
Of course, Upgrading won't always beat the market. And it's important to realize that Upgrading is the rare actively-managed strategy that has been able to even keep up with the market's returns over an extended period of time. You see, the dirty little secret of professional investing is that most actively-managed investments -- including most mutual funds, planner/broker portfolios, newsletter strategies, etc. -- fail to keep up with the market. Traditional money management is founded on the questionable assumption that professional managers can consistently beat the market through research, intelligent risk-taking, and exploiting the mistakes of others. But that assumption has largely proven to be false.
It turns out that the secret to winning the money game may be to not try winning at all. Let's look at an analogy from the world of tennis. I have spent many an afternoon risking bodily injury and public humiliation on the tennis courts. As a beginner, I concentrated my efforts on trying to learn how to hit the ball correctly. My strategy had little to do with specific plans for hitting the ball to my opponent's forehand or backhand or placing it shallow or deep. My primary concern was pretty simple: Try to keep the ball in bounds! I lost many more points due to the mistakes I made than as a result of the actions of my opponents.
In his book on tennis strategy, Extraordinary Tennis for the Ordinary Player, Dr. Simon Ramo describes the kind of amateur tennis I play as a "loser's game." By that he means it is the kind of competition where the winner is determined by the behavior of the loser. The amateur doesn't win by defeating his opponent; he wins by letting his opponent defeat himself.
Ramo contrasted this with the "winner's game" played at the professional tennis level. In those matches, we are accustomed to seeing consistently precise serves, stunning recoveries, and long, dramatic rallies. Eventually, one player takes a calculated risk and attempts to put his opponent away with an exceptionally powerful or well-placed shot. At the expert level, it is the winning of points that drives the action and determines the outcome.
In short, Ramo observed, amateurs lose points and professionals win points. To test his hypothesis, he compiled an extensive database of points scored in actual tournaments at both levels. He found a surprisingly consistent and symmetrical tendency. In professional tennis, about 80% of the points are won due to superb offensive execution -- a winner's game. On the other hand, in amateur tennis about 80% of the points are lost due to unforced errors -- a loser's game.
OK, so what does this have to do with selecting a mutual fund portfolio? In his highly acclaimed book Investment Policy, money manager Charles D. Ellis applied Ramo's work to the investing arena. When Ellis studied the investment markets, he saw that it was not uncommon for 80% of the managers of stock and bond mutual funds to underperform their respective markets. In their efforts to "score" for their shareholders, they were hitting the ball into the net or out of bounds far too often. It appeared that investing had become a loser's game. According to Ellis, it hadn't always been this way:
