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Inversion Thinking: How Charlie Munger Avoids Stupidity with Investing

In today’s post, we are going to discuss some ways to use inversion thinking to avoid stupidity when making investing decisions.

Using a framework established by Stoics such as Marcus Aurelius, Seneca, and Epictetus, and by more modern thinkers such as Charlie Munger and Howard Marks. We can use their ideas and thoughts to help us avoid losing money by eliminating mistakes.

In today’s post, we will discuss:

  • What is Inversion Thinking?
  • Origins
  • Charlie Munger’s influence
  • How to Avoid Stupidity

Ok, enough preamble, let’s get to it.

What is Inversion Thinking?

Inversion is thinking of what you want to achieve in reverse. Another way to put it is instead of thinking about the future results, and what you want to achieve, you think to flip it in reverse and think about what you don’t want to happen.

For example, instead of worrying about striking out while batting, instead, think about making contact. Or, if you are terrified about a presentation at work and worrying if it is good enough, instead focus on eliminating any mistakes in your performance, such as insufficient data, bad slides, or technical malfunctions.

Inversion thinking is a skill that we learn in life; typically, this type of thinking is not approached in school-based learning. It is a subject that I stumbled across as I read more Charlie Munger and listened to his speeches.

It is far easier to avoid failures than to strive for brilliance.

This concept can easily be applied to investing, which is a subject that we will explore more deeply in an upcoming section.

Art is an excellent example of inversion thinking. Great art breaks all the previous rules; Michelangelo was one of the world’s foremost artists in both marble and paint. He accomplished this by continually evolving and breaking the previous rules.

If you study his work with marble, you can see the sculptures come alive in his hands. He often stated that he didn’t create his sculptures; instead, he released them from the marble. If you have ever had the chance to see any of his works in person, you will be stunned by the lifelike effects he creates, especially compared to the other sculptures from the same period.

To achieve his ability, he studied cadavers to learn human anatomy to enable him to bring more lifelike characteristics to his sculptures. At the time, this was forbidden, but he proceeded anyway because he determined this was an avenue to make his art more lifelike and more believable.

Charlie Munger and His Impact on Inversion Thinking

“Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead – through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.”

Charlie Munger

Easily my favorite quote from Charlie and full of so much wisdom and with, which is typically Charlie.

Charlie Munger, for those two or three of you not familiar with him, is Warren Buffett’s sidekick at Berkshire Hathaway. And a brilliant investor in his own right, along with one of the most profound thinkers I have come across.

Charlie is fond of saying:

I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity.

A great example of this is Ben Graham’s “margin of safety” concept, a straightforward concept that people try to overthink. The idea is easy; if you buy a company for less than its worth, even if you make a mistake on your valuation, you can still do well financially.

For example, if we buy a company for less than 30% of its intrinsic value, we create a cushion based on our calculations that can help avoid mistakes caused by stupidity.

The desire to avoid mistakes is why Seth Klarman refers to value investing as the risk-averse approach. I think this is also why Buffett’s rule number one, don’t lose money quote is so applicable to value investing. It is the avoidance of losing money or doing something stupid that helps us win in the long run.

Don’t complicate the margin of safety rule, calculate the intrinsic value of a company with a conservative approach, buy with a margin of safety, and then wait. It is that simple, but we humans have to make things complicated and difficult because we try to be too smart.

That is why the hardest part of value investing is the mental aspect, the psychological and emotional, rather than the system itself.

Another aspect of inversion that Charlie discusses often is the idea of loss-aversion. When we fail at something, especially if it is a painful experience, we tend to remember it. For example, if you buy a company and then the price plummets, and we lose a great deal of money. That experience will stay with us forever and might prevent us from ever attempting to reinvest.

Instead, say you buy a different company, and the gain is the reverse of the loss, we tend not to have a strong memory of that gain as we do the loss.

Think about that time you fumbled over the first time you tried talking with a girl or boy that you liked. It was embarrassing, and you felt completely awkward and stupid.

But after that, you had lots of successful interactions with someone you liked a lot, maybe even date. But you still hang onto that one painful experience.

We always feel the pain of loss much more than we do the comparable gain.

Larry Bird, the Hall of Fame basketball player once said in an interview that he hated to lose more than he loves to win; it was an incredible motivating factor for his success.

Loss-aversion is a powerful force and a significant component of inverted thinking. Approaching a subject and reversing the outcome you want to achieve can help you achieve the desired result by avoiding the loss.

Origins of Inversion Thinking

Where did inversion thinking originate? How did we come across this idea and who were some of the early proponents of this type of thinking.

Stoics

Ancient philosophers such as Seneca, Marcus Aurelius, and Epictetus were early practitioners of a version of inversion thinking, also known as Stoics (AD 63-65).

Their idea was to conduct what they referred to as a premeditation malorum, which from Latin translates as a “premeditation of evils.”

The goal of this practice was to envision all the negative things that could happen in life. For example, the Stoics would imagine what it would be like to lose their home, or become ill, lose their status in society, or lose their reputation.

The Stoics believed by imagining the worst possible circumstances ahead of time allowed them the ability to overcome their fears and create better opportunities to avoid them.

Most people focus on how they achieve success; the Stoics also approached how they would handle failure. What would everything look like if it all wend lousy tomorrow, and how do we prepare for this possibility?

Carl Jacobi

More recently (1820), German mathematician Carl Jacobi, expressed that hard problems in math could be solved by inverting them, his idea “man muss immer umkehren,” which translates to invert, always invert.

You might recognize that phrase, as this is where Charlie Munger picked it up from Carl Jacobi.

Tim Ferris

Most recently, Tim Ferris, in his excellent TED talk in 2017, presented his ideas on inversion thinking. He had three points to his presentation:

  • Identify fears
  • Benefits of risks
  • Loss of inaction

Tim gives a very compelling presentation, and combined with the article I linked too; some efficient exercises can help you create your own fear-setting goals.

Inversion is a powerful thinking tool because it helps highlight errors and roadblocks that are not obvious from the outset.

We are moving on to how we can apply these inversion thinking concepts to investing to help us avoid mistakes.

How to Use Inversion To Avoid Mistakes

Avoiding mistakes in an under-appreciated way to succeed, in any line of work, but especially with investing.

You can achieve some degree of success in work by showing up every day and performing your work to your best ability, even if we are not the smartest, most talented, or wisest.

We all want to make more money, and if you are reading this post, it is because you have an interest in investing as your chosen way of making more money. For us, how we would we destroy our investing success?

Is taking more risk the answer to enormous wealth? Or is leveraging yourself to hilt with more debt to squeeze out a few more percentages the path to wealth?

These are questions we must ask ourselves as we decide what kind of investor we want to be. Most think that they need to be the cleverest investor or have these complicated processes to achieve success. Is this the way, to quote the Mandalorian. But I digress……

Charlie Munger and Warren Buffett are unquestioningly intelligent people; one could argue investing geniuses. But both attribute their success to a straightforward factor, avoiding mistakes.

Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them.”

Warren Buffett

Both Buffett and Munger have found the best way to achieve success was to avoid failure by consistently avoiding stupidity.

Let’s construct a step-by-step guide to inversion for investing.

  • Figure out what you want to achieve
  • What do we want not to happen, or worst-case scenario?
  • How could the worst-case scenario occur?
  • How can we avoid the worst-case?

Envision that we are ten years down the road, and our favorite investment has gone entirely sideways, and we have lost a ton of money. Do we have to ask ourselves what went wrong?

Another way to think is, why this is not a good investment.

The first part of the equation is easy to figure out; we all want our investments to grow and create long-term wealth for us. Simple and straightforward.

Example from The Pandemic World

For the next part, let’s use a real-life example that is occurring right now in Pandemic World, where if you can imagine it going wrong, then it will.

Let’s take a company like Exxon that deals in oil.

What is the worst-case scenario for a company that works with oil? The price of oil completely tanking and demand to dry up to the point of none use.

What would happen to your investment in Exxon if this occurred? Would the company go bankrupt? Would they lose market share to some other oil producer, or would they become victim to some other utility rising in popularity such as electric cars, for example?

Flash forward to today, April 21, 2020, and those very scenarios are a reality. Oil prices have fallen to negative $37 a barrel, never before seen levels. And demand has dried up completely because everyone is confined to their homes and can’t drive, air travel has evaporated as well. There is also the pressure of developing electric cars which threaten to take over the automotive world. All of these fears are becoming a reality in the world and threaten the long-term health of the oil industry.

Does this mean that Exxon is going out of business? No, not at this time, but it indeed threatens at the outset a reduction or elimination of their dividend, loss of jobs, and a reduction in the overall value of the company.

Just recently, Exxon was trading for around $71 a share in November 2019; currently, it is $40 as of writing this article. Is that a permanent loss of capital, no, but it is alarming especially with all the alarm bells sounding about the recovery of the economy and other pressures on oil as a commodity.

As an example of inversion thinking, you would attempt to look at what could be the worst possible circumstances and anticipate how the company would react to them, and if that would justify an investment with them.

You would have to ask yourself, is the risk worth investing in a volatile sector like oil commodities worth your time and effort? Or is it in the too-hard pile, and we move on to some other opportunity?

As an investor, it is crucial to think of all the possible ways an investment could fall apart. Charlie likes to say he spends as much time tearing apart his investment ideas as he does creating them. It helps him invert his ideas and look for possible flaws.

Regardless of the sector, you have competence in; you need to approach all of your investments with a strategy of inversion thinking.

Some ways to help you avoid these mistakes.

  1. Buy stocks with an adequate margin of safety; this helps avoid stupidity when assessing intrinsic value.
  2. Avoid investing in risky companies and a loss of permanent capital.
  3. Stay within your circle of competence, and try to avoid acting outside of it. It is better to understand what you don’t understand.
  4. When calculating an intrinsic value calculation such as an DCF (discounted cash flow), try to invert the market’s expectations of growth. If Wall Street growth estimations are unreasonable in your eyes, walk away.

Long-term success in investing is more about avoiding losers than picking winners.

A good analogy would be that hare never wins the race. If you focus on avoiding mistakes and stick to your process, in the long run, you will win the race. Avoid getting caught up in the excitement of picking the biggest winner. For everyone who claims they were in on Amazon when it first started, how many losers did they choose as well? You never hear about that, but it is true. For every lucky pick, they achieve there are hundreds of losers they tried before that.

Final Thoughts

Inversion thinking is counterintuitive but an essential tool for all great thinkers. It is not apparent to spend time thinking about what you don’t want to happen.

But yet inversion is a crucial tool of many great investors such as Charlie Munger, Warren Buffett, Howard Marks, Seth Klarman, and so on. All capable value investors practice some form of inversion thinking by creating a margin of safety with their investments or sticking to their circle of competence.

Inversion can be particularly useful in challenging our own beliefs in investing. When you buy a stock, you are putting your opinion and views about a company out there in the market. Inversion helps you look at the company from all angles, the buyer and seller’s viewpoint.

Inversion can help prevent us from making up our minds from the first thought. Better stated, it is a way to counteract the gravitational pull of confirmation bias, one of the most deadly sins in investing. By attempting to destroy all of your investing ideas, you avoid falling into the trap of finding evidence that confirms your viewpoint, that is what inversion thinking can help you avoid.

With that, I am going to wrap up our discussion on inversion thinking.

As always, thank you for taking the time to read this post, and I hope you find something of value for your investing journey.

If you have any further questions or if I can be of any additional assistance, please don’t hesitate to reach out.

Until next time.

Take care and be safe,

Dave