The good is mostly in the absence of the bad.
– Old proverb, mentioned in Nassim Nicholas Taleb’s Antifragile.
Why is it important to avoid investment mistakes? Put simply, if you avoid the gravest mistakes, winning tends to take care of itself.
Avoid unforced errors
In 1975 Charles D. Ellis wrote a famous article in The Financial Analysts Journal called The Loser’s Game, quoted in Howard Mark’s The Most Important Thing.
Ellis spends part of his article referencing a book by Simo Ramo called Extraordinary Tennis for The Ordinary Tennis Player. Ramo was a scientist and statistician and he embarked on a project studying tennis matches played by both professionals and amateurs. Ramo concluded:
In expert tennis, about 80 percent of the points are won; in amateur tennis, about 80 percent of the points are lost. In other words, professional tennis is a winner’s game – the final outcome is determined by the activities of the winner – and amateur tennis is a loser’s game – the final outcome is determined by the activities of the loser.
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If you are an amateur, the game is won by the opponent doing too many blunders, ie. double-faults, hit the ball too hard, or hit the net. The best strategy is simply to return the ball in the least risky way and wait for the opponent to do a mistake.
In tennis, this is called unforced errors and is something being reported throughout any professional game in the major tournaments.
What is the relevance of unforced errors in investing?
It’s actually very important. Just read what Charlie Munger says about error removal:
It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.
– Charlie Munger
Mr. Munger is famous for his inverse thinking. Instead of looking at ways to win, Munger argues you can study the most common ways to lose, and then simply focus on avoiding them.
In The Education Of A Speculator, Victor Niederhoffer writes that there are so many ways to lose, but so few ways to win. With this in mind, the best strategy is perhaps simply to focus on disasters and then concentrate on avoiding them.
This is the basis of Charlie Munger’s inverse thinking: If you want good returns, study what you need to do to get poor returns. We can say success equals good returns minus low returns. You simply need to remove “low returns” and the good returns will take care of themselves. Simple in theory, not so easy in practice.
Unforced errors make compounding very hard:
What happens if you are not invested in the worst 5 days every year?
In an article on Seeking Alpha, the author “Ploutos” looked at what would happen if you were not invested in the five worst and best days of 2020. Avoiding the worst days is of course only achievable in hindsight, but it serves as a reminder of the importance of avoiding disasters.
The pink line below shows how 100 would have grown to almost 150 if you avoided the five worst days. The blue line shows the S&P 500, which as of writing is down only 1% for the year (July 2020). The red line shows is the result of missing the five best days.
Because the pink line avoids the disaster days, it starts off at a higher base when the good times return.
Very negative returns impair your long-term compounding
If your portfolio drops 50%, it needs to rise 100% to recover the paper loss. Big variations in your portfolio are thus a handicap.
Not only are you more liable to do behavioral mistakes, but you need to recoup a lot of the losses. Given two portfolios with an equal expected return, the portfolio with the lowest variations is preferred.
The math is simple:
Let’s assume you have two portfolios A and B. Both have returned an average of 10% over many years, but portfolio A has had a lot more variations in the return than B. But an average return can be very misleading. We need to look at geometrical return, CAGR, and not average return.
Portfolio A looks like this:
Portfolio B looks like this:
Even though both portfolios had an average 0% return in those two years, both portfolios made a negative return. Portfolio B was best because it had the least variations in yearly returns.
Thus, very negative returns have a dramatic impact on your ability to compound.
The most important thing is to avoid ruin
It’s difficult to recover after a big loss, both financially and emotionally. As a private investor, you need to have a reasonably diversified portfolio. Otherwise, you face the risk of loss of capital and subsequent difficulties to recover. The more you lose, the more return you need to recover the losses:
The chart above explains pretty well why you should always aim to preserve your capital.
For example, if you lose 80% of your capital (shown on the x-axis as 20% of your capital remaining), you need a 400% return to get back to break-even. Obviously, that is not an easy task.
But financial theory says you get paid to take risks?
Unfortunately, you don’t.
The author “Ploutos” published an article on Seeking Alpha in February 2019 that looked at performance and variations for all stocks from 1963 to 2018. The results are summarized in this table:
|Lowest||Second lowest||Second highest||Highest|
|Lowest mkt cap||16.73%||17.54%||15.58%||10.48%||-2.75%|
|Second lowest mkt cap||15.20%||16.10%||15.64%||12.99%||3.43%|
|Second biggest mkt cap||12.69%||13.00%||12.96%||12.02%||6.90%|
|Biggest mkt cap||9.72%||10.87%||10.15%||8.95%||7.81%|
The table clearly states the mediocre performance of the stocks which have the most volatility. The small-cap group with the highest volatility even managed to produce negative returns all the way back to when JFK was elected!
Clearly, the stock markets are not as efficient as what you are being taught in school.
Any unnecessary risk-taking and subsequent losses can put a real drag on our compounding. Avoiding unforced errors is thus very important.
Make sure you stay within your circle of competence!