Avoiding unforced errors in investing
- June 27th, 2012
Wimbledon is now underway. While my interest in tennis has declined greatly since the retirement of Borg, Connors and McEnroe one concept from the game still sticks with me. That is the concept of forced and unforced errors. I can only think of one other sport, baseball, that goes to the trouble of documenting errors. First let’s define our terms. From Wikipedia:
- forced error: Miss caused by an opponent’s good play; contrasted with unforced error. Counting forced errors as well as unforced errors is partly subjective.
- unforced error: Error in a service or return shot that cannot be attributed to any factor other than poor judgement and execution by the player; contrasted with forced error.
These definitions make more sense when you think about what competition in the financial markets looks like. This reminds me of a passage from Meir Statman’s book What Investors Really Want: Discover What Drives Investor Behavior and Make Smarter Investment Decisions. In that piece Statman compares playing tennis with trying to beat the market. He writes:
Buying and selling Japanese yen, American stocks, French bonds and all other investments is not like playing tennis against a practice wall, where you can watch the ball and place yourself at just the right spot to hit it back when it bounces. It is like playing tennis against an opponent you’ve never met before. Are you faster than your opponent? Will your opponent fool you by pretending to hit the ball to the left side, only to hit it the right?
Let’s first stipulate that the financial markets are going to do whatever they darn well please. There is nothing any individual can do to affect the overall direction of the markets. Therefore active management is much like trying to play tennis against a professional player. This leaves the individual investor open not only to forced errors but unforced errors as well. The financial markets have a tendency to fool as many investors it can as often as it can. Can an individual investor score some points against the market? Sure, but the odds are that the market will on average return more volleys that you can’t handle.
Unforced errors are a different matter entirely. By definition an unforced error involves “poor judgment or execution.” These are things that an individual investor does have largely with their control. Nobody can eliminate unforced errors, from their game, even the best players in the world make mistakes, but you can strive to reduce them to insignificant levels.
The biggest unforced error investors make is choosing to play, oftentimes unknowingly, the active management game in the first place. The fact is that most investors, indeed the vast majority, don’t have the time, inclination or interest in trying to engage the markets in this sort of fashion. If you accept market outcomes as a given, and not try to outwit the market, you can help eliminate many forced errors. The next great challenge for investors is to focus on their own behaviors and take what the market gives you.
The kind of strategies I talk about in my book Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere are all focused on eliminating unforced errors as well. This means portfolio strategies that focus on diversification, low expenses and minimizing taxes. In short, trying to benefit from what the ETF industry via lower expenses and using the market’s own moves to help rebalance a portfolio and do other things like tax-loss harvesting.
Much of the financial services industry is built on its ability to convince you to trade, buy actively managed funds and complex products that are designed more with broker compensation in mind than investor needs or desires. You the investor can choose to opt out of the game of forced errors and focus on strategies that by definition help eliminate unforced errors.
You cannot be a mediocre, much less outstanding tennis player and make it to Centre Court at Wimbledon. The funny thing about investing is that investment mediocrity is eminently achievable. You need not go through the trouble of trying to become a great investor to enjoy the benefits of investing. In fact one could argue it has never been easier to construct a cheap an efficient portfolio than ever before. Investment mediocrity may not be as exciting than hitting tennis balls against a practice wall, but it is preferable than the long odds that most investors now face through the accumulation of forced (and unforced) errors.
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- Friday links: exercising your strengths
- Thursday links: understanding Wall Street
- 6 Essential Principles from Pragmatic Capitalism by Cullen Roche
- Wednesday links: the multiplier effect
- Tuesday links: knowledge alone
- To bond ETF or not: an excerpt from Rational Expectations by William Bernstein
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- Sunday links: paralyzed with fear
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