No matter how optimistic you are about the stock market, there's one thing you should always remember: Investing in stocks is a loser's game.
He said it! I didn't.
At least that's what investment pioneer Charles D. Ellis called it in his classic 1975 article, "The Loser's Game." In the prize-winning piece, Ellis compared stock market investing to a game of tennis played between two amateurs.
Why amateurs? Because as opposed to professional tennis matches, which are marked by few mistakes (a "winner's game"), amateur matches are filled almost entirely with unforced errors (a "loser's game"). Therefore, the best strategy for an amateur to take is to, well, not try so hard! Amateurs should simply focus on getting the ball inbounds and letting their opponents beat themselves.
In other words, the key to a loser's game is to avoid mistakes at all costs ... just as with investing.
It's no secret that it's incredibly tough to beat the market. Anywhere between 75% and 90% of mutual funds underperform the S&P 500 -- a fact that we Fools aren't shy to point out. And it's exactly that type of evidence, according to Ellis, that makes investing a perfect example of a loser's game.
Institutions -- with their armies of analysts and their hyperdiversification across hundreds of stocks -- have essentially become the market. The competition has grown so large, the playing field so even, that it's extremely tough to pull off brilliant investment "shots" with any regularity. I mean, is it really possible to have useful insights into Intel (Nasdaq: INTC ) or Advanced Micro Devices (NYSE: AMD ) that the 30-plus chip-savvy analysts covering them don't?
When you consider the incredible degree of difficulty in trying to "out-trade" Wall Street, one thing becomes painfully clear: Most of us aren't good enough to overcome such huge odds.
The best thing to do is stay passive, buy an index fund, and avoid mistakes. Just like a loser's game should be played. Unless, of course, you really want to be a winner.
Caution: For dedicated investors only
Though the evidence suggests that beating the market is improbable, that doesn't necessarily make it impossible. Luckily, for those who are absolutely bent on beating the market (like most of us here at Fooldom), Ellis suggests a couple of tips to consider.
Tip 1: Play your own game
Great investors always look for an edge. In other words, market-trouncing masters tend to invest only when their knowledge of a given business is superior to that of the vast majority of investors.
Of course, no one exemplifies discipline and staying within one's "circle of competence" like Berkshire Hathaway CEO Warren Buffett. By pouncing on easy-to-understand businesses such as Procter & Gamble (NYSE: PG ) , PetroChina (NYSE: PTR ) , and Nike (NYSE: NKE ) -- when Mr. Market offered them at an uneducated price -- Buffett has delivered compounded returns of more than 20% for decades. Despite being a self-described technophobe, Buffett has done exceptionally well by sticking to his rules.
"How do you beat Bobby Fischer?" Buffett once asked. "You play him at any game but chess."
Tip 2: Keep it simple
Next, Ellis suggests that investors deliberately bring turnover down to make better, more focused decisions. Everything counts. And if you plan to outperform over the long haul, you really can't afford to dilute your portfolio with subpar opportunities.
So instead of knowing a "little bit" about hundreds of stocks, why not increase your chances of success by knowing a few businesses cold? After all, history has proved that just a couple of bang-on insights -- like spotting the genius business acumen of Microsoft's (Nasdaq: MSFT ) Bill Gates in the mid-'80s, or how far ahead of the networking curve Cisco Systems was in the early '90s -- are enough to make an entire investment career.
As Buffett says, "You only have to do a very few things right in your life so long as you don't do too many things wrong."
Make the winning move
For most investors, setting out to thump Mr. Market will only prove to be an uphill battle. But by strictly adhering to a couple of time-tested tips, you certainly can be a winner in this loser's game called stocks. Of course, if you simply don't have the time to find superior investments, maybe we can help.
David and Tom Gardner, lead advisors over at our Motley Fool Stock Advisor service, have helped subscribers outdo the market for years. By sticking to their own areas of expertise and by being extremely selective, Tom and David's picks are up 73% versus the S&P's 30% since inception in April 2002. For a peek at the winning scorecard and their best ideas for new money now, take a free 30-day trial run today.
This article was originally published Nov. 5, 2007. It has been updated.
Fool contributor Brian Pacampara is a natural-born loser at all racket sports, and he holds no position in any of the companies mentioned. The Motley Fool owns shares of Berkshire Hathaway. Intel, Microsoft, and Berkshire Hathaway are Motley Fool Inside Value picks. Berkshire is also a Stock Advisor selection. The Fool's disclosure policy always wins by a landslide.