The Tragedy of Errors

Lawn Chair LarryLarry Walters had always wanted to fly.  When he was old enough, he joined the Air Force, but his poor eyesight wouldn’t allow him to become a pilot. After he was discharged from the military, he would often sit in his backyard watching jets fly overhead, dreaming about flying and scheming about how to get into the sky. On July 2, 1982, the San Pedro, California trucker finally set out to accomplish his dream. But things didn’t turn out exactly as he planned.

Larry conceived his project while sitting outside in his “extremely comfortable” Sears lawn chair. He purchased weather balloons from an Army-Navy surplus store, tied them to his tethered Sears chair and filled the four-foot diameter balloons with helium. Then, after packing sandwiches, Miller Lite, a CB radio, a camera and a pellet gun, he strapped himself into his lawn chair (see above). His plan, such as it was, called for his floating lazily above the rooftops at about 30 feet for a while and then using the pellet gun to explode the balloons one-by-one so he could float to the ground.

But when his friends cut the cords that tethered the lawn chair to his Jeep, Walters and his lawn chair didn’t rise lazily. Larry shot up to a height of over 15,000 feet, yanked by the lift of 45 helium balloons holding 33 cubic feet of helium each.  He did not dare shoot any balloons, fearing that he might unbalance the load and cause a fall.  So he slowly drifted along, cold and frightened, with his beer and sandwiches, for more than 14 hours. He eventually crossed the primary approach corridor of LAX.  A flustered TWA pilot spotted Larry and radioed the tower that he was passing a guy in a lawn chair at 16,000 feet.

Eventually Larry conjured up the nerve to shoot several balloons before accidentally dropping his pellet gun overboard. The shooting did the trick and Larry descended toward Long Beach, until the dangling tethers got caught in a power line, causing an electrical blackout in the neighborhood below. Fortunately, Walters was able to climb to the ground safely from there.

The Long Beach Police Department and federal authorities were waiting. Regional safety inspector Neal Savoy said, “We know he broke some part of the Federal Aviation Act, and as soon as we decide which part it is, some type of charge will be filed. If he had a pilot’s license, we’d suspend that. But he doesn’t.” As he was led away in handcuffs, a reporter asked Larry why he had undertaken his mission. The answer was simple and poignant. “A man can’t just sit around.”

As Larry’s story shows, the world is full of foolish people, and that foolishness can lead to situations that are extremely risky and fraught with danger.  But none of us needs to be as foolish as Larry was to create big problems for ourselves. We need only be human. For example, a famous study by the U.S. Institute of Medicine concluded that up to 100,000 people die each year due to preventable medical errors. Since physicians are among the smartest and most highly trained professionals imaginable, being a dope is obviously not a prerequisite for making major mistakes.

Nearly all of us do monumentally stupid things sometimes, especially as teenagers.  But we also make choices that turn out badly because we lack knowledge or are at least ignorant of the possible consequences of them. We also make dreadful miscalculations sometimes and exercise monumental errors in judgment. Other times we get lousy outcomes because of garden variety error. It happens. We all make mistakes. Occasionally things go wrong because of fraud or active malfeasance by someone.   And sometimes a combination of factors and people conspires to mess things up, as shown below.

Whatever its form and cause, it’s clear that human error abounds. Our inherent behavioral and cognitive biases ensure as much. Unfortunately, even though most of us are willing to acknowledge a wide array of poor decision-making exhibited broadly and generally, we tend to fail to expect or recognize the problem personally. Note, for example, the following clip of an interview on Fox News that exploded on the web recently wherein a Muslim scholar took offense to an accusation of bias.

In my view, what is remarkable here is not that a news commentator would suggest the possibility of a guest’s bias. We’re all biased, including the Muslim scholar, so I see nothing wrong with pointing out potential bias. But that the anchor seems  to think that Muslim thinkers are inherently more biased and agenda-driven than other (presumably white and Christian) talking heads such as herself. In fact, she seems to imply that she’s “fair and balanced.”  As if!

The unvarnished reality is that we’re all biased as a matter of course. We’re wildly overconfident about the future and reinforce it with self-serving bias – our tendency to see the good stuff that happens as our doing but the bad stuff as just plain bad luck. Thus we think good results are due to our smarts, skill and hard work while lousy results are outside of our control.  We don’t think we’re foolish, just unlucky. 

That said, sometimes bad outcomes are attributable to bad luck (randomness).  In poker, for example, sometimes a terrific hand gets beaten by an adversary drawing to an inside straight.  The adversary’s betting on such a long shot (with just over an 8 percent chance) would be foolish — a clear error — but sometimes it works out and the player who made the better decision ends up losing. That’s a simple fact of life.

Due to what Nobel laureate Daniel Kahneman calls the “planning fallacy,” our ability to control the future is extremely limited and is far more limited than we want to believe. It is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof.  It’s at least partly why we underestimate the likelihood of bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect.  It’s why the results we achieve aren’t as good as we expect.  It’s why I take three trips to Home Depot on Saturdays and take eight hours to finish a household chore I expected to take 30 minutes. We are all prone to foolishness and error…all the time (those who still resist this characterization and are married can be set straight by their spouses).

In all probabilistic fields, where both luck and skills contribute to success, the best performers dwell on process. This is true for great value investors, great poker players, and great baseball players. A great hitter focuses upon a good approach, his mechanics, being selective and hitting the ball hard. If he does that – maintains a good process – he will make outs sometimes (even when he hits the ball hard) but the hits will take care of themselves over the long haul.  Maintaining good process is really hard to do psychologically, emotionally, and organizationally.  But it is absolutely imperative for investment success. How precisely to go about doing that it the operative question.

We all recognize intuitively that risk and reward are, at least roughly, inversely related. The problem is always how to attempt to balance them and which side of the equation to overweight. The better answer is that dealing with risk must come first.  The reason for doing so is what I call the error quotient.  In sum, it means that it helps much more to avoid making errors than it does to be smart and make good picks. Because error is everywhere, avoiding it gets you well on the way to investment success. 

Let’s break that down a bit.

Every year the Dalbar QAIB examines actual investor returns and every year the suffering of the individual investor is made plain.  The latest data shows that for 2012, the average equity investor underperformed by 0.42 percent and the average fixed income investor underperformed by 0.47 percent. To those not comfortable with statistics, that may not seem substantial, but over the past 20 years, the average equity investor has suffered an aggregate underperformance of nearly 50 percent while the average fixed income investor has suffered an aggregate underperformance of nearly 85 percent. That level of underperformance is enormous, especially when it is compounded over time.

The S&P Dow Jones Indices most recent year-end report confirms this problem, showing once again that actively managed funds — where managers try to be smart and beat the market by making good investment choices — tend to underperform their benchmarks. In 2012, performance lagged behind the benchmark indices for 63.25 percent of large-cap funds, 80.45 percent of mid-cap funds and 66.5 percent of small cap funds. Similarly, the S&P Dow Jones Indices latest persistence report yet again shows that even those few funds that come out on top can’s consistently stay there.

Out of 703 funds that were in the top quartile as of March 2011, fewer than 5 percent of them managed to stay in the top quartile over three consecutive 12-month periods at the end of March 2013. For the three years ended March 2013, 16.57 percent of large-cap funds, 14.22 percent of mid-cap funds and 23.05 percent of small-cap funds maintained a top-half ranking over three consecutive 12-month periods even though random expectations would suggest a rate of 25 percent. Over the longer-term, only 2.41 percent of large-cap funds, 3.21 percent of mid-cap funds and 4.65 percent of small-cap funds maintained a top-half performance over five consecutive 12-month periods even though random expectations would suggest a repeat rate of 6.25 percent.  Thus actively managed funds, in general and in the aggregate, underperform their benchmarks and fail to maintain their outperformance when they actually achieve it — by a lot. 

Hedge funds, the least regulated and most highly compensated area within the finance sector, if anything, have performed even worse.  In his book, The Hedge Fund Mirage, Simon Lack, a hedge fund insider from his long tenure at JPMorgan Chase, showed that the hedge fund industry as a whole lost more money in 2008 than it had made in all of the previous 10 years. Even worse, “if all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good,” especially since nearly all the hedge funds’ gains went to managers rather than clients. Indeed, venture capital and private equity, key drivers of hedge fund returns, have underperformed for a decade or more.

Lots of really smart people are using essentially all their time trying to get ahead in the markets. A vanishingly small number of people are actually succeeding. Being smart has demonstrated very limited upside overall.

Indeed, good research suggests that our industry has become ever more sophisticated and complex over the past three decades or so but to little effect.  In fact, fully 2 percent of GDP has been wasted in the pointless hypertrophy of the financial sector – we got paid more but didn’t produce more – evidence that America’s financial system is less a device for efficiently sharing risk and more a device for separating customers from their money. Moreover, there is no correlation between stock market valuation measures or GDP and Wall Street rewards. Being ever smarter hasn’t helped our clients very much.

Not only is it really hard to beat the market overall, but when you do make a smart investing move (purchasing an investment that will actually outperform, however you define that), its impact is reduced every time somebody else follows suit.  It is axiomatic in the investment world that as an asset class becomes more popular, it suffers from both falling expected returns and rising correlations.  Good trades get crowded and their advantages tend to disappear.  Crowding occurs because success begets copycats as investors chase returns.  General mean reversion only tends to make matters worse.  In other words, the more smartness there is in the aggregate, the less you can profit from it. Michael Mauboussin describes it as the paradox of skill: ”As skill improves, performance becomes more consistent, and therefore luck becomes more important.” In investing, therefore, as the population of skilled investors has increased, the variation in skill has narrowed, making luck increasingly important to outcomes. Being smarter helps less.

That investing successfully is really hard suggests that being really smart should be a big plus in investing.  Yet while it can help, the existence of other smart people together with copycats and hangers-on greatly dilutes the value of being market-smart.  On the other hand, the impact of bad decision-making stands alone.  It isn’t lessened by the related stupidity of others.  In fact, the more people act stupidly together, the greater the aggregate risk and the greater the potential for loss.  This risk grows exponentially. Think of everyone piling on during the tech or real estate bubbles. When nearly all of us make the same kinds of poor decisions together — when the error quotient is really high — the danger becomes enormous. 

As Phil Birnbaum brilliantly suggests in Slate, not being stupid matters more — demonstrably more — than being smart when a combination of luck and skill determines success. Suppose you are the GM of a baseball team and you’re preparing for the annual draft. Avoiding a mistake helps more than being smart.

Suppose you have the 15th pick in the draft. You look at a player the MLB consensus says is the 20th best player and think he’s better than that — perhaps the 10th best player. By contrast, the MLB consensus on another player is that he’s the 15th best player but you  think he’s only the 30th best. If you’re right about these players, what does that gain you when the draft comes?

If the underrated player is available when your turn comes along, you can snap him up for an effective gain of five spots. You get the 10th best player with the 15th pick. Of course, since everybody else is scouting too, you may not be the only one who recognizes the underrated player’s true value.  Anybody with a pick ahead of you can steal your thunder.  If that happens, your being smart didn’t help a bit. 

If the overrated player is available when your turn comes up along (in theory, he should be because he’s the consensus 15th pick and you’re picking 15th), you’re going to pass on him, because you know he’s not that good. If you hadn’t done the scouting and done it right, you would have taken him with your 15th pick and suffered an effective loss of 15 spots by getting the 30th best player with the 15th pick.  In that case, then, avoiding a mistake helped. 

Moreover, it doesn’t matter if other teams scouted him correctly. You’re helped no matter what. Recognizing the undervalued player (being smart) only helps when you’re alone in your recognition. Recognizing the overrated player (avoiding a mistake) always helps. Birnbaum’s moral: “You gain more by not being stupid than you do by being smart. Smart gets neutralized by other smart people. Stupid does not.” That’s the importance of the error quotient.

The same principle can be demonstrated mathematically, as Birnbaum also notes. Gather 10 people and show them a jar that contains equal numbers of $1, $5, $20, and $100 bills. Pull one out, at random, so nobody can see, and auction it off. If the bidders are generally smart, the bidding should top out at just below $31.50 (how much less will depend on the extent of the group’s loss aversion), the value of the average bill {(1+5+20+100)/4}. If you repeat the process but this time let two prospective bidders see the bill you picked, what happens? If you picked a $100 bill, the insiders should be willing to pay up to $99.99 for the bill. Neither of them will benefit much from the insider knowledge. However, if it’s a $1 bill, neither of the insiders will bid. Without that knowledge, each of the insiders would have had a 1-in-10 chance of paying $31.50 for the bill and suffering a loss of $30.50. On an expected value basis, each gained $3.05 from being an insider. Avoiding an error matters more than making a smart decision.

As Charley Ellis famously established, investing is a loser’s game much of the time (as I have also noted before) – with outcomes dominated by luck rather than skill and high transaction costs.  If we avoid mistakes we will generally win. We all want to be Michael Burry, an investor who made a fortune because he recognized the mortgage bubble in time to act accordingly.  But becoming Michael Burry starts by not being Wing Chau, an investor of Lawn Chair Larry foolishness who got crushed when the mortgage market collapsed. In fact, we all suffered when the real estate bubble burst.  When the error quotient is really high, our risks grow exponentially.

The tragedy of errors is that errors cost us more than good decisions help. When nearly everyone is smart together, nobody wins.  When nearly everyone screws up together, nearly everyone loses and loses much more than they otherwise would have. The more universal the error, the greater the loss. Because this tragedy of errors is such a major problem, dealing with risk first is absolutely essential for good investing. Thus learning what not to do is more important than learning what to do. Error abounds. There are Lawn Chair Larrys everywhere. We can be that kind of stupid far more often than we’d like to think. But garden variety error and just plain bad luck are killers too. Keeping your error quotient low provides the best opportunity for investment success. Master that before you try to be smart.

9 thoughts on “The Tragedy of Errors

  1. Thank you Bob for providing food for thought on the benefits of error prevention. Too many investment professionals are focused entirely on the benefits of return and ignore the dangers of risk.

    Having said that, I have two issues with this post.

    The first is that the sample size used to reach the conclusion for under-performance seems a bit low (3-5 years as opposed to a longer investment horizon). If Warren Buffett underperforms the S&P for a 3 year period, will that diminish his investing prowess or his shareholder’s faith in his ability to find attractive value bargains?
    This point seems more tailored to speculators (with short investment horizons) than long-term investors.

    The second issue is that you raise the issue of herding behavior on good trades diminishing returns but doesn’t this herding behavior also provide an opportunity for someone who isn’t following the herd to profit from an attractively priced hedge or from other opportunities which may now be overlooked or ignored because of overcrowding?

    I’d love to hear your thoughts.

    • I included the 3-5 year SPIVA numbers to show the lack of persistence — a lack of persistence lower than random chance would suggest. That’s important even though we can all agree that even the best investors can suffer a blip and that longer-term numbers mean more.

      Herding does *offer* opportunities to a careful contrarian. Of course, it’s easier said than done.

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  5. Its a very long and convoluted way of saying cut your losses and manage your risk. imo this is meant for general public to stay stupid by making it sound esoteric.

    • I would suggest that the application is much broader than that. For example, it suggests an investment *approach* designed to limit the potential for error.

      Thanks for reading and commenting.

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