Unforced Errors

Posted by Myles Brandt, CFP® on 18 March 2010 | 0 Comments

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Maria Sharapova went into the semifinals of the LA Women's Tennis Championship in 2009 clearly favored to win. Yet, she was beaten by the 10th seeded Flavia Pennetta from Italy. Critics said it was her serve and the recent shoulder surgery. What I noticed during the match was that Sharapova had 61 unforced errors and Pennetta had 23. Unforced errors are mistakes that are supposedly not forced by your opponent. They are mistakes that could have been avoided. Pennetta won not because she played well, but because Sharapova played badly.

Financial types like to make an analogy between tennis and investing because of one essential similarity. Investing and tennis are what game theory calls zero-sum games. For every trade there is a winner and a loser. When you make a mistake it is someone else's gain. Consistency pays. Limiting your unforced errors is essential.

So what is an unforced error in investing? It's simply when one security blows up and drastically affects your overall performance. It's the chance that a Citigroup, Wachovia, Lehman Brothers, Enron or any failed or severely crippled business has a large position in your portfolio. Sooner or later most of them will fail. However, you won't know it has failed until it's too late. So the best course of action is to diversify to the point where it won't affect your portfolio. Get rid of potential unforced errors. The chart below shows different types of risk.

Beta measures volatility relative to the total market. A beta higher than the market's beta of 1 implies more volatility, and a beta lower than the market's implies less volatility.

The chance of having a real dog in your portfolio (Citigroup, Enron, etc.) is company risk. The chance of having too much exposure to banks is industry risk. These are both sources of unforced errors. The chance that the market goes down is market risk. You can diversify out of company and industry risk. You cannot diversify out of market risk. You only get paid for market risk. So why take risks that you don't need to?

Many investors like to speculate on individual stocks. That's fine as long as they recognize that to be speculation. A real investment, however, is more intelligent than that. By diversifying out company and industry risk, investors can minimize their unforced errors every time and tilt the odds back in their favor.

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