One of the many lessons I took from playing basketball as a kid was minimizing turnovers. Let’s say each team normally has thirty possessions per game, but your team has five turnovers. This results in your team having twenty-five possessions compared to the other team’s thirty-five. Your opponent’s ten extra shots will probably decide the game in their favor. This simple math produces a discipline to avoid unnecessary mistakes. There will always be turnovers, but you don’t have to make things easier for the other team by making a lazy pass and committing an unforced error.

Unforced error is a term largely used in tennis where we see matches between low to intermediate skilled tennis player decided by who makes the least mistakes. I think this idea is applicable to almost anywhere in life but doubly so for investing. When it comes to investing no one is really competing against another team. Instead, you’re competing against some ideal future version of yourself where good decisions are a boon for you and turnovers detract from your future prosperity. Charlie Munger’s quote rings loudly here,

“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.”

Many people who hunt for market beating returns don’t realize the difficulty of the task and how the search can end up harming their investment portfolio. Below are just a few of the unforced errors we commonly see.

Stock Picking

When most people think about investing, they have an image of smart portfolio managers and analysts examining different companies to build the best market beating portfolio possible. The problem is fund managers consistently underperform compared to their benchmarks. The below picture shows 90% of funds underperforming vs the S&P 500 over a fifteen year time span and you can find more poor track records here. This underperformance isn’t because fund managers are incompetent. Many of them are brilliant and would probably improve society by shifting their career focus towards medicine or physics. They fail because the market is efficient enough at pricing new information that it is very difficult to beat in the long run. A smart fund manager is competing against thousands of other smart managers and the algorithms they build. The market then rapidly absorbs their opinions into the price of any given security through their purchase orders, sale orders, and various options contracts.

High Expense Ratios

Every now and then you’ll see a cool story about a long thought extinct animal being rediscovered in some corner of the rainforest or ocean. The Coelacanth is one such animal and I’m still holding out hope for the Tasmanian tiger. This is similar to investment management where there are plenty of practices you thought went extinct but are very much alive and well. One surprisingly extant practice is high expense ratios. Expense ratios are mutual fund and ETF management fees. When you see the investment return of a mutual fund or ETF, it probably doesn’t include the expense ratio. Your net investment return is the gross return minus the expense ratio. A good practice in portfolio construction should be to keep fees as low as possible since the higher fees are, the more they detract from your net investment return, which is the amount you actually take home. For some reason I thought the era of high expense ratios was over. I was wrong. In the Year of Our Lord 2023 AD, I have seen mundane mutual funds with expense ratios as high as 2%, and nearly averaging 1% across an entire portfolio.

Concentration Risk

Concentration risk is the danger of having too much of an investment portfolio allocated to a single asset, a handful of assets, or even an entire sector. It’s sort of like packing all your military capabilities into a Death Star instead of diversifying firepower across the Imperial Starfleet. Concentration can work wonders when it goes well (attacking Alderaan) and can blow up your financial circumstances when it goes bad (losing the Battle of Yavin). Naturally, concentration risk is going to be more dangerous for investors who are heavily reliant on their portfolio for lifestyle needs where a large loss can have a significant impact on their long-term financial health.

Market Timing

Most of us have heard the adage “buy low and sell high.” While the saying makes perfect sense it is actually very difficult to pull off. One of my favorite stories is Sir Isaac Newton’s experience with the South Sea Bubble of 1720. Newton was an early investor in the South Sea Company and profited handsomely as the company’s stock price rose. When the South Sea craze began, Newton liquidated his position at a nice profit, but then South Sea’s stock price continued to rise. Smart man that he was, Newton decided to get back in the game and bought the stock near its peak, right before it cratered. Newton is alleged to have quipped he could, “calculate the motions of the heavenly bodies, but not the madness of people.”

Another challenge to market timing is that market returns during a bull market are not evenly distributed. If you read books about geological history you’ve probably come across debates over gradualism vs catastrophism. Gradualism argues that changes to the earth’s surface occur slowly over long periods of time, while catastrophism states that every so often a major event dramatically reshapes the earth’s surface. When we calculate return estimates, we often use a gradualist approach by assuming a seven percent return per year. However, in practice the market is closer to catastrophism. A large portion of the returns during economic good times can stem from single days or weeks during an eight-year stretch. Missing just one of those days can harm your investment returns.

Too Conservative or Aggressive Allocation

One of the more interesting subjects in financial advising is the relationship between risk preference and risk capacity. Risk preference is entirely subjective. It’s your own assessment of your comfort zone and how much risk you believe you can handle. It’s your own opinion on whether you could beat a grizzly bear in a one on one death match. Risk capacity is an attempt to measure what you can actually handle. If the market drops 30%, how does that impact your financial position and do you need to make lifestyle changes? Can you actually win a fight against a grizzly? No, you won’t win this fight.

It's important to understand the difference between risk preference and capacity because your ability to handle risk isn’t only defined by your present assets, but by your age as well. An investor in their 20s might be risk averse and opt for a portfolio that is 50% stocks and 50% bonds, but since a 25 year old has a longer time horizon until retirement, being too conservative is robbing their future self of a higher investment return. This young investor would be correct to assess that stocks are more volatile than bonds, but the further you are from retirement the more likely you are to capture the risk premium stocks have over bonds. Conversely, if you are near retirement and have too much exposure to stocks, you risk volatility and a decline in your portfolio just when you might start drawing money from it.

These are just a few of the unforced errors you might come across as an investor, but I think the concept can also be applied to financial planning and life more generally. Maximize each possession of the ball by minimizing turnovers. Life throws enough curve balls at us as is. There is no need to make things harder with unforced errors.  

Epilogue: The Soap Box

Unforced errors are not confined to sports, portfolio management, and the individual. When I see the above pie chart, I imagine an alternate timeline where the universe is in near perfect alignment.  Eighty percent or more of our electricity in this beautiful timeline would be generated emission free largely thanks to nuclear energy. It’s a wonderful world to imagine because if France (the owners of this gorgeous energy mix) could do it, why not us? Instead, we live in the dark timeline. In the 1980s our future was stolen. We were robbed, hoodwinked, taken for a ride, deceived, and bamboozled. America’s future energy grid was crucified on a cross of black smoke, but it wasn’t oil companies that drove in the nails. Fair weather environmentalists (you’ll never see them off the marked hiking trail) condemned us to decades of unnecessary carbon emissions. How their progeny continue to harass progress is a topic for another day, but if you care about the environment beyond the sloganeering, then the cradle strangling of nuclear energy is one of the great unforced errors of modern American history.