Charles Ellis on Values Discovery

“The “winner’s game” of rigorous, individualized values discovery and counseling may not be as financially rewarding to investment managers as the performance “product” business based on price discovery, but as a profession, it would be far more fulfilling.” – Charles Ellis

Charles Ellis, author of the classic book investment book Winning the Loser’s Game, came up with one of my favorite analogies for the investment process.

In the book he compares investing to professional tennis. The best players in the world hit enough solid shots until their opponent finally makes a mistake (the winner’s game). On the other hand, amateur tennis players tend to lose points because they make basic mistakes and unforced errors (the loser’s game). Simply cutting down on unforced errors and reducing mistakes can help you become a better investor.

Ellis has a new research paper out in the Financial Analysts Journal that offers even more great advice for investors and the industry as a whole. He makes an important distinction between price discovery and value discovery (emphasis mine):

Ideally, investment management has always been a “two hands clapping” profession: one hand based on skills of price discovery and the other hand based on values discovery. Price discovery is the skillful process of identifying pricing errors not yet recognized by other investors. Values discovery is the determination of each client’s realistic objectives with respect to various factors, including wealth, income, time horizon, age, obligations and responsibilities, investment knowledge and personal financial history, and designing the appropriate strategy.

The media and most active mutual fund managers focus almost exclusively on price discovery. While this is an interesting exercise, it’s probably not the correct focus for 95% of investors out there that have neither the time nor skill-set to compete in that space. Ellis discussed this in the paper:

Although not as exciting as competing on price discovery, investment counseling based on values discovery is greatly needed by most investors—institutional investment committees as well as individual investors—and surely offers more opportunities for real long-term success to both our profession and our clients.

The problem is that many in the industry haven’t figured this out yet.  Since most average investors don’t understand investments or the financial markets, many get caught up in listening to the first intelligent-sounding piece of advice they stumble across.  They assume picking stocks or paying attention to economic data is the key to investing and miss out on all of the basics of this so-called values discovery.

While Ellis agrees that there are specialized investment managers that can beat the market:

such managers are small in capacity, hard to identify in advance, and limited in how much they will accept from any one client or even closed to new accounts, and so they cannot accommodate more than a modest fraction of potential institutional demand.

Of course there are investors that can beat the market. And there always will be. You just have to determine if you are able to choose them in advance and be able to tell if you understand their investment process enough to figure out if it’s repeatable over longer investment horizons. This is not easy as Ellis points out:

The challenge is to select a manager sufficiently more hardworking, more highly disciplined, and more creative than the other managers—managers that equally aspirational investors have already chosen—and more by at least enough to cover the manager’s fees and compensate for risks taken.

Again, this is not impossible, but it’s not easy either. Markets are in no way perfectly efficient, but that doesn’t mean beating the market is a walk in the park. It’s always been a difficult task over long time frames, but the increase in skill and competition makes it much harder now than it was in the past.

And at the end of the day, markets are complex systems that are never easy to completely understand, as Ellis so eloquently pointed out:

Forecasting the future of any variable is difficult, forecasting the interacting futures of many changing variables is more difficult, and estimating how other expert investors will interpret such complex changes is extraordinarily difficult.

This is why Benjamin Graham once said, “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.”

The Rise and Fall of Performance Investing (FAJ)

Further Reading:
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