Avoid false positives in your investing

In criminal justice system, “it is better to let the crime of a guilty person go unpunished than to condemn the innocent.” [US Supreme Court 1895]

Broadly speaking, in any system where there is uncertainty and incomplete information, there are two types of decision errors that people make: false positives (example: convicting an innocent person) and false negatives (e.g. acquitting a guilty person). In statistics, they are formally called Type I and Type II errors respectively.

Changing rules to reduce false positives will increase false negatives (and vice versa), assuming everything else remains constant. It is a balancing act. For this reason, William Blackstone wrote this in 1769:

It is better for ten guilty persons to escape than for one innocent person to suffer.

Something similar happens in the investing world too. False positives (falsely identifying a good opportunity) have an inverse relationship with false negatives (missing a good opportunity). False positives are errors of commission where we mistakenly commit to a bad business. False negatives are errors of omission when we ignore a wonderful business that could have done well in our portfolio.

So which error type should long-term investors aim to reduce: false positives or false negatives?

To answer this, we must first realize that there are far more bad investments out there than good ones. A study done by Hendrik Bessembinder (finance professor at Arizona State University) showed that just 4% of all publicly traded businesses accounted for all the wealth creation in the US stock market in a recent 90-year (1926-2016) period.

Let’s say there are a total of 1000 stocks available, out of which only 200 are good businesses. The rest 800 are duds. With 10% false positive error rate, we’d have picked 80 bad investments for our portfolio. 10% false negatives would mean we’d miss out on 20 good ones. Pretty clear where we need to focus: Reduce our false positives and bring bad apples down from 80.

Another way of saying this is that the errors of commission are far more consequential than the errors of omission.

We are striving to avoid false positives in our portfolios, but in return we do need to accept the possibility of increasingly missing out on some good investments too (false negatives). Buffett and other smart investors instinctively understand this balance. Hence, we see media talks frequently about Buffett’s missing out on some hugely successful businesses. And yet, Buffett has beaten nearly every other investor over the long run. A key to his success: he avoids false positives even at the expense of potentially increasing his false negatives. He is OK with that.

It goes without saying that an investor can’t realistically be expected to pick all market beating stocks for his portfolio. No investor bats a thousand. But it only takes a few big winners for the portfolio to do very well and even beat the market. See Chris Mayer’s The 100-Baggers.

How do I reduce false positives in my stock picking? For one, I look for high quality businesses with durable competitive advantage, owner-founder management, proven profitable business models, selling at reasonable valuations. See this.

Another way to avoid false positives is by having fewer new investments (even when they score high on above factors) in favor of adding to existing positions. For instance, I wrote in a blog post in 2023 that all my new buys in the 2022 market downturn were incremental adds to my portfolio. Not a single purchase was a new name at the time. This year’s dry powder purchases also have just one new name in it: Taiwan Semiconductor (TSM).

Lately, I only buy stocks when the market is down, usually adding to my existing positions. I rarely invest in new stocks. This is a way to reduce false positives in my portfolio. I’m increasing stakes in companies that I know very well. I have owned them for a decade or more. I trust their managers and understand their business dynamics. I’ve seen them navigate a crisis or two.

Contrast this with buying shares of a company for the first time. There is a much higher chance of a false positive there.

Let’s also talk about passive investors who only buy stocks through ETFs or index funds.

Charles Ellis wrote a timeless classic on passive investing titled Winning The Loser’s Game. He defines a “loser’s game” as one where the outcome is determined by mistakes made by the loser. The other kind of game, a winner’s game, is where a player’s correct actions make him the winner.

Ellis suggested that amateur tennis is a loser’s game. The player who makes more unforced errors usually lose. Not so much as the winner’s winning plays.

More relevant to our discussion here, he also called individual investing a loser’s game. Only if we investors could avoid making unforced errors, we’d come out ahead. What are those unforced errors that investors make: getting in and out of the market frequently, not making and not following a long-term plan, making decisions based on emotions or whims, etc.

Seven years ago, I wrote a blog post here (Most investors underperform the stock market) on fund investors’ chronic underperformance versus the benchmark indexes. I pointed out that half of the underperformance can be attributed to investors’ own actions like panic selling, exuberant buying, and attempts at market timing. These are all errors of commission i.e. unforced errors. As Ellis pointed out in his book, if passive investors could learn to avoid these, they’ll come out ahead of most other investors.

Postscript: The stock market has mostly recovered from the panic of early April. Consequently, I haven’t made any new purchases since April 7^th. Last month, I reported those purchases were up by 10%. Today, they are up by 25%. See below update. As always, I wait patiently until a new crisis happens.