Charlie’s most important lesson
Recently I was helping my 12 year old son Charlie do some of his maths homework and he had been taught that when you switched a number from one side of the equals sign to the other you needed to invert the number. That got me to thinking about possibly the most important lesson I have received from his namesake, Charlie Munger. Inversion.
Perhaps his most well-known use of inversion was:
“Tell me where I am going to die, so I don’t go there”.
Which is funny, witty and about as deeply as most people (including for an embarrassingly long time myself) consider the issue of inversion. However, there are a lot more important lessons to be learnt. My favourite overview was provided by Charlie himself at the Daily Journal Annual Meeting in 2020:
“Part of the reason that some of the companies I’ve been affiliated with that have been successful, it’s not that we’re so smart, it’s that we stayed sane. A lot of what goes on is absolutely nuts.
One of my favourite tricks is the inversion process. To give an example: When I was a meteorologist in WW2 they told me how to draw weather maps and predict the weather. But what we were actually doing is to clear pilots to take flights. And I just reversed the problem, I inverted.
I said suppose I wanted to kill a lot of pilots, what would be the easy way to do it? I soon concluded that the only easy way to do it was to get so much ice on the planes that they couldn’t handle it or to get the pilot to a place where he’d run out of fuel before he could safely land [He was stationed in Alaska].
So I made up my mind I was gonna stay miles away from killing pilots by either icing or getting them sucked into conditions where they couldn’t land. I think that helped me be a better meteorologist – I just reversed the problem …
Every great algebraist inverts all the time because the problems are solved easier …
Young [people] should do the same thing in their ordinary walks of life. You don’t think of what you want, you think of what you want to avoid. When you’re thinking of what you want to avoid you also think about what you want.”
Now I don’t know about you but to me that is pretty important advice and is certainly a lot more nuanced than the more widely referenced example. So how might this thinking help the average investor?
Well, it certainly applies at the macro level. How do you achieve financial independence? Invert it; how do you ensure that you don’t achieve financial independence? Spend more than you earn; waste money on stuff you don’t need to impress people who don’t matter; don’t have a goal, a target; look for quick buck solutions.
How do you have a happy life? Invert it; how do you have an unhappy life? Choose the wrong friends, role models, partners; succumb to envy; seek external rather than internal validation; always choose the easy rather than the right option.
But what about at a more micro level? Well, when we are making an investment it is common to focus more on the upside. However, I would argue that the easiest way to minimise your risk of loss is to invert the question – what can go wrong with this investment? Is the size of the investment appropriate if the worst case scenario happens? If fear and greed are behaviourally present in all investment decisions, then doesn’t it make sense to at least give the fear part equal billing in making the investment decision?
Leithner & Company Ltd has managed money for its shareholders for just over 23 years. In that time, we have made money on over 90% of realised share investments (that is, sold. Until an investment is realised the final result is unknown. This is also the reason we only get paid on realised profits!). That is an extraordinarily high number – the last time I looked it up the average US mutual fund made money on only around 60% of its investments. Reasons for the disparity are likely two fold; firstly we focus first and foremost on not losing money (we ask what can go wrong) and secondly we have a much longer investment time frame than the average manager (albeit a personal rather than Leithner & Co example, have a read of my article “From dreadful mistake to 12 bagger – why it (sometimes) pays to hang in there” to give you some idea of how dogged we can be). On the other hand there are a no free lunches in this world.
What is likely to happen if you focus heavily on the downside of investments? You will avoid a lot of “sins of commission” (as outlined above) however you will likely commit a lot more sins of omission. Simply, you will miss out on a lot of investments if your discount rate is too high, your expectations too pessimistic. We have consciously made that decision; we accept that we may have lower returns over time because we take less risk. (As an aside though, both empirical and anecdotal evidence suggests that focussing on not losing money doesn’t unduly harm overall long term returns. Not having to earn 100% to recoup a 50% drawdown is a good starting point.)
So, in life, both real and financial, consider using the inversion tool in making your decisions – you might just make less mistakes.
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David has both a Bachelor of Laws and a Masters of Applied Finance. He is also a Solicitor of the Supreme Court of Queensland. David’s career started in law in 1994 before devoting his focus to financial services from 1996. Since then, his career...