Why It Is Important To Avoid Investment Mistakes – Minimize Unforced Errors

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 short, 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.

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 reported throughout any professional game in major tournaments.

What is the relevance of unforced errors in investing?

It’s essential. 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 need to remove “low returns,” and the positive 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 preventing 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 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 expect