Why Warren Buffett Sees Investing as a Loser’s Game

Inversion is a powerful tool for decision-makers

Photo: PM Images/Getty Images

My favorite fable as a child was Aesop’s “The Tortoise and the Hare,” about the famous race between a fast, arrogant rabbit and his much slower, shelled counterpart. After gaining a sizable lead, the hare decides to take a nap during the race, believing his victory is all but assured, until the hare wakes to find that the tortoise has passed him. Despite making a mad dash toward the finish line, the hare comes up short and loses the race.

While most people see the moral of the story as “don’t be overconfident” or “slow and steady wins the race,” I see it as a warning against terrible decision-making. After all, it is the hare’s bad decisions, not the tortoise’s good decisions, that lead to the hare’s defeat.

Warren Buffett said it best: “Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero.”

Investment consultant Charles Ellis applies this framework in his book Winning the Loser’s Game:

In a winner’s game, the outcome is determined by the correct actions of the winner. In a loser’s game, the outcome is determined by the mistakes made by the loser.

Ellis explains how investing is inherently a loser’s game, because most investors who attempt to beat the market (those who try to win) typically underperform in the long run. For example, using excessive leverage or paying high fees for expected outperformance are two common ways in which would-be winners become definite losers.

The better strategy for investors, then, is not to try and win, but to not lose. Too many people in the financial community obsess over the “optimal” way to invest, when their time would be better spent steering clear of actions that could lead to ruin.

Warren Buffett said it best in his Berkshire Hathaway letter to shareholders in 2005:

Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero.

The warning from Ellis and Buffett alike is crystal clear: Avoid the zeros. Avoid them at all costs. Why? Because the zeros are those things that can set you back years, or decades, in an instant.

In the investment world, the zeros are typically variables associated with high costs (fees, taxes, extravagant spending, etc.) or high risks (leverage, concentration, etc.). All of these things, if not managed properly, can wreak havoc on your finances.

In his book Antifragile, Nassim Taleb refers to this approach as via negativa, Latin for “the negative way,” and thoroughly demonstrates the powerful health benefits associated with adhering to it:

Durin Burch, in Taking the Medicine, writes: “The harmful effects of smoking are roughly equivalent to the combined good ones of every medical intervention developed since the war. Getting rid of smoking provides more benefit than being able to cure people of every type of cancer.”

As Taleb illustrates, avoiding negative behaviors has done more for individual health than the cumulative effect of many positive medical interventions.

So, how do you avoid the zeros? To start, let’s illustrate how this approach would work through a simulation.

Imagine you have a choice between two assets to invest in:

Asset A returns +4% in 99% of periods and –96% in 1% of periods. The expected return for this asset in one period is +3%: (0.99*0.04)+(0.01*–.96)=0.03.

Asset B returns +1% in all periods.

Given these options, which asset would you prefer to invest in?

If you had to invest for only one period, most of you would likely pick Asset A, because odds are you’ll land a +4% return. But what if you had to invest for 100 periods — or 1,000 periods?

To test the outcome of these scenarios, I ran 1,000 simulations of each asset, with the assumption that you invested $1 into each. Here are the results for the median simulation across the first 50 periods:

As you can see, Asset A completely dominates Asset B, because a majority of the simulations have not experienced their 96% loss—yet.

But if we extend this simulation out to the first 100 periods, you will notice the results aren’t quite the same:

Now Asset B leads Asset A (starting around the 70th period) as more than half of the simulations (including the median simulation) have experienced their 96% loss. But what happens if we keep going?

At 1,000 periods, one of the assets begins to permanently pull away from the other:

Why does this happen? While Asset A has higher returns than Asset B in most periods (4%>1%), Asset A also has catastrophic returns in some periods that it cannot make up for in the long run.

Put another way, Asset B performs better because it “avoids the zeros”—the large, infrequent losses—unlike Asset A.

You might be wondering how it’s possible that Asset A underperforms Asset B for the majority of the simulations despite having a higher expected return.

I used to think my edge in life was being smart, but it really isn’t. My edge is being not stupid. There’s a big difference.

While this is true in the median simulation, this is not necessarily true if we take the average across all simulations.

When we take the average, Asset A easily outperforms Asset B, since a smaller number of simulations of Asset A experience few (if any) 96% losses across 1,000 periods. Those few lucky simulations would completely skew the average in favor of Asset A over Asset B.

Just look at how ridiculous the results become when using the average outcome across all simulations for the first 1,000 periods:

In this instance, Asset A clearly dominates — though only due to luck. You can imagine how someone might market Asset A without disclosing that this is the result of chance.

But you don’t have to imagine this hypothetical scenario, because this is exactly what many “zero” investment strategies do. They ignore all the losers and market the winners to unsuspecting victims. They have to do this, because no one in their right mind would hand over their money to these financial charlatans if they saw all the zeros.

Avoiding the zeros in all aspects of life

I used to think my edge in life was being smart, but it really isn’t. My edge is being not stupid. There’s a big difference.

Case in point: Myron Scholes, the Nobel Prize–winning economist, is far smarter than I am, yet I have the better-performing investment record. Anyone who knows about Scholes’ magnificent losses with Long-Term Capital Management (LTCM) can attest to this.

How is it possible that a Nobel laureate can have a worse investment record than a typical investor like me? Well, it turns out that the Nobel Prize winner played a stupid game. In the case of Myron Scholes and LTCM, that stupid game was called leverage.

How do I know it was stupid? Because if Warren Buffett only levered 1.6-to-1 throughout his career, why would you ever go beyond this limit, let alone 50 times over it, as LTCM often did?

As the saying goes, “Play stupid games, win stupid prizes.” So, don’t play.