Corporate investment: do you play the loser's game?

Corporate investments: do you play the loser's game?

Those who hire outside investment managers don't always understand what the loser's game is all about. It was identified by Simon Ramo of TRW fame. A tennis buff, he examined that sport and found there are two games of tennis. They look the same. Both use the same equipment, the same dress code, the same court, the same scorekeeping system. But, after that, they deviate radically. Those of you who watch hours of good tennis on television are watching a game called "winner's" tennis, in which the only way to score a point is to hit the ball just past your opponent's reach and just within the lines.

That's not the game I play. My game has double faults, net balls, out-of-bounds shots, and other blunders. It's a very different game. In the game that lendl and company are playing, you win points. In the game that I love so much, we don't win points--we lose points.

A winner's game is one where the outcome is determined by the behavior of the winner. A loser's game is one where the outcome is determined by the behavior of the loser. And investment management, which was, in the '40s and the '50s, still a winner's game in which the bold and active investor could surely come out ahead, has, I believe, switched to being a loser's game. Those who try too hard will lose.

How does one become a loser in investment management? First, ignore the cost of activity. Pay no attention to the reality that in order to break even as an active manager you must outperform the market averages--before transaction costs and other expenses--by about 20 percent.

Second, romanticise the way the world works. Do not be concerned that we spend $4 billion a year motivating some of our most brilliant, articulate, and well-prepared individuals to persuade investment managers to change their minds and do something different. If you haven't had the privilege of sitting before the onslaught of talent, persuasion, and perfection of indecision that we call Wall Street, you owe it to yourselves to sit where the investment managers sit and see if you can withstand the blandishments.

Third, seek the physical solution to the investment puzzle. Work harder, read more reports, go to more dinners, fly to more distant cities, get up earlier, make more telephone calls--trying physically to outproduce your competitors. This macho role is intriguing, but there are very few capable of outsmarting the whole crowd, so success is an unlikely prospect. The alternative is to do what I have done, which is emotionally difficult: Be boring, uninteresting. Care not whether markets go up or down. Be patient and faithful to your long-term purpose.

Fourth, confuse policy decisions, strategy decisions, and trading decisions. A policy decision is a decision that you can put in an envelope, give to a stranger, and say, "You can act on this decision anytime you want over the next year or two, but when you take action, it must stay in place for at least a decade." That's a policy decision.

A strategy decision is the same proposition, except it is exercised over the next couple of months. And whatever you do has to stay in place for at least a few years.

Anything else is a trading decision. Do you remember the old saying about poker? If, after 20 minutes, you don't know for sure who the patsy is, you're the patsy? Well, if you don't know what a trading decision is, it's like the poker game. That's what you're doing, making trading decisions.

The loser concentrates on what the evidence appears to show has been working. Most of that evidence has about a three-year base, and it leads almost all of us these days to get excited about tactical asset allocation, growth stocks, stock options, portfolio insurance, and so on. I would urge you to keep in mind that marvelous dictum from the Greeks: those whom the gods would destroy they first make confident.

Hands-off investing

Now, how do you win? First, you establish a mix of assets that is right for your particular plan over the long, long term. Then you give it enough time so its results are driven not by news but by history. A boring idea? Maybe, but hold on to it. Don't let anyone tinker with it. I'm reminded of a kindergarten sign in Vail, Colorado: "Leave your children for the day, $5. You watch, $10. You help, $25!"

Remember Bob Kirby's wonderful advice last year in Institutional Investor? To choose the right investment managers, find a group whom you admire and respect. From that group, choose those who have the worst three-year performance record. Hire them. And then be big enough, strong enough, wise enough, and determined enough to leave them be.

I have been asked how much diversification is needed to play the winner's game. A great advantage of diversification is that it forces you to invest in things you don't want to own. And it's those investments that often come up and give you a nice caress, when the ones that you thought for sure loved you turn on you and are unfaithful.

There is a lot to be said for keeping investment management as dull and uninteresting as possible, so that you can snooze through difficulties, maintain the fundamentals, and do the right thing for the long haul. If it's interesting, it is not fiduciary.

But if you make decisions with that long-term view, many ask, how do you assure that you can survive in your job until the results are in? The answer is to establish an understanding within your organization that makes you independent of short-term concerns.

You must never have your real client, members of the corporation's core decision-making group, surprised. They may not like some news, they may be amazed, but they must never be surprised--and never shaken loose from a persistence on the longer term.

How many of your internal clients, your directors, your senior executives genuinely understand the behavior of capital markets? My suspicion is not as many as you would like. That's the major problem.

So teaching your organization is the first part of professionalism. The second is to remember that investment managers are not going to understand fully your overall situation, and they are not deeply interested in setting long-term asset mix or basic policy. Their job is operational, not policy.

The second role in professionalism is for everyone to know that you are in charge. The most important work in institutional investment management is setting appropriate long-term policy and holding on to it. That's the responsibility of you as the client.

Next stop, the Olympics

I'd like to close with some comments about why there is so much pressure coming from Wall Street to play the loser's game, why there are so many more new and imaginative instruments to entice you into short-range thinking. It begins, in a way, with the students coming out of the leading business schools.

If you take just the top third of the class, over half go to Wall Street. These kids are brilliant. They're ambitious. They've had a taste of success in their work before returning to school, and they know how to play the game. Now they sense the opportunity to become a partner, which in those firms is not penny-ante stuff. It's an extraordinary experience.

First, these are achievement-minded people, and they rise to challenge as though they have something personal to prove. Second, there's the psychological kick of having achieved excellence against a kind of international intellectual competition. They're competing with one another within each firm, with those in other firms, and soon, they realize, with the best minds of other countries, too. For them, Olympic competition pales as an alternative. And, third, there is the chance to make a fortune if you can come up with new and compelling propositions.

All of this captures the interest of people in their twenties and thirties as never before. And with their facile minds--along with computers that can manage all kinds of data--they have what they need to create new kinds of securities. There's a lot of ambition out there, and there's a lot of creativity. The action in today's capital markets is mathematically sophisticated, very innovative--and compels activity. Your investment managers are being drawn into the play. The freedom of choice is going up exponentially. And it is exciting.

But please remember that when freedom of choice is greatest, we most need policy. To paraphrase Chesterton: freedom of choice tends to confuse; absolute freedom of choice confuses absolutely. Managers will have more freedom of maneuver in portfolio operations. And clients will have more responsibility to govern through wise, long-term policy.