In today’s post, we will discuss ways to use inversion thinking to avoid stupidity with 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 the following:
- What is Inversion Thinking?
- Charlie Munger and His Impact on Inversion Thinking
- Origins of Inversion Thinking
- How to Use Inversion to Avoid Mistakes
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 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 we learn; typically, we don’t approach this type of thinking in school-based learning. It is a subject that I stumbled across as I read more about Charlie Munger and listened to his speeches.
It is far easier to avoid failures than to strive for brilliance.
We can apply this concept easily to investing, a subject 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 painting. 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 natural characteristics to his sculptures. At the time, studying human anatomy wasn’t allowed, but he proceeded anyway because he determined this was an avenue to make his art more lifelike and 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 – through sloth, envy, resentment, self-pity, entitlement, and 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.”
Easily my favorite quote from Charlie, full of so much wisdom and so typically, Charlie.
For those two or three of you not familiar with him, Charlie Munger is Warren Buffett’s sidekick at Berkshire Hathaway, and a brilliant investor in his own right and 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 inversion remains Ben Graham’s “margin of safety” concept; a straightforward concept people try to overthink. It remains an easy idea; 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. The avoidance of losing money or doing something stupid helps us win in the long run.
Don’t complicate the margin of safety rule; calculate a company’s intrinsic value 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 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 Charlie often discusses is the idea of loss aversion. When we fail at something, especially a painful experience, we tend to remember the experience. For example, if you buy a company and the price plummets, you lose a great deal of money. The experience will stay with us forever and might prevent us from ever attempting to invest again.
Instead, say you buy a different company, and the gain is the reverse; we tend not to have a strong memory of the gain as we do the loss.
Think about when you fumbled over the first time you tried talking with a girl or boy you liked. It was embarrassing, and you felt completely awkward and stupid.
But after that, you had many successful interactions with someone you liked, maybe even date. But you still hang onto that one painful experience.
We always feel the pain of loss much more than the comparable gain.
Larry Bird, the Hall of Fame basketball player, once said in an interview that he hated to lose more than he loved to win, and that was a great 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 loss.
Origins of Inversion Thinking
Where did inversion thinking originate? How did we come across the idea, and who were some of the early proponents of this type of thinking?
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 called a premeditatio malorum, which translates from Latin as a “premeditation of evils.”
The goal of the Stoics was to envision all the negative things possible in life. For example, the Stoics would imagine losing their home, becoming ill, losing their status in society, or losing their reputation.
The Stoics believed that imagining the worst possible circumstances ahead of time allowed them to overcome their fears and create better opportunities to avoid them.
Most people focus on achieving success; the Stoics also approached how they would handle failure. What would everything look like if it all went lousy tomorrow, and how do we prepare for this possibility?
More recently (1820), the German mathematician Carl Jacobi expressed that math could solve hard problems 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.
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; 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 is an under-appreciated way to succeed in any line of work, especially with investing.
You can succeed by showing up daily and performing your work to the best of your ability, even if you are not the smartest, most talented, or wisest.
We all want to make more money, and if you continue reading this post, it is because you want to learn more about investing as your chosen way of making more money. For us, how would we destroy our investing success?
Can taking more risk equal the answer to enormous wealth? Or can we leverage ourselves to the hilt with more debt to squeeze out a few more percentages on the path to wealth?
We must ask ourselves these questions to decide what kind of investor we want to become. Most think they need to become the cleverest investor or have these complicated processes to succeed. “This is the way,” to quote the Mandalorian. But I digress……
Charlie Munger and Warren Buffett operate as unquestioningly intelligent people; one could argue they are investing geniuses. But both attribute their success to a specific factor: avoiding mistakes.
“Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them.”
Both Buffett and Munger have found that the best way to achieve success is 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 what is the worst-case scenario?
- How could the worst-case scenario occur?
- How can we avoid the worst-case?
Envision 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 remains easy to figure out; we all want our investments to grow and create long-term wealth. Simple and straightforward.
For the next part, let’s use a real-life example occurring right now in Pandemic World, where if you can imagine it going wrong, 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? Oil prices are completely tanking, and demand to dry up to the point of no 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 another utility rising in popularity, such as electric cars?
Flash forward to today, April 21, 2020, and those very scenarios are a reality. Oil prices have fallen to -$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 also evaporated. The pressure of developing electric cars also threatens 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 Exxon is going out of business? No, not right now, but the dropping price threatens at the outset of a reduction or elimination of their dividend, loss of jobs, and a reduction in the company’s overall value.
Just recently, Exxon was trading for around $71 a share in November 2019; currently, it is $40 as of writing today’s article. Does the dropping price equal a permanent loss of capital? No, but the price remains alarming, especially with all the alarm bells about the economy’s recovery and other pressures on oil as a commodity.
As an example of inversion thinking, you would attempt to look at the worst possible circumstances, anticipate how the company would react to them, and if that would justify an investment.
You would have to ask yourself, is the risk of 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 another opportunity?
As investors, we must consider all 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.
Here are some ways to help you avoid these mistakes.
- Buy stocks with an adequate margin of safety; this helps avoid stupidity when assessing intrinsic value.
- Avoid investing in risky companies and a loss of permanent capital.
- Stay within your circle of competence, and try to avoid acting outside of it. It is better to understand that you don’t understand.
- When calculating an intrinsic value such as a DCF (discounted cash flow), try to invert the market’s growth expectations. 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 the hare never wins the race. If you focus on avoiding mistakes and stick to your process, you will win the race in the long run. Avoid getting caught up in the excitement of picking the biggest winner. For everyone who claims they invested early on with Amazon when it first started, how many losers did they choose as well? You never hear about those, but they never admit the whole truth. For every lucky pick they achieve, they have hundreds of losers they tried before.
Inversion thinking remains counterintuitive but an essential tool for all great thinkers. Most investors don’t spend time thinking about what they don’t want to happen.
But yet, inversion is a crucial tool for 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 put your opinion and views about a company 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 will 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, a self-taught investor, empowers investors to start investing by demystifying the stock market.