Invert, always invert

I’m very proud of my investing record over the last 6 years as a professional (beating roughly 80% of my competitors) and the last 15 years as an individual (beating the S&P 500 by over 4.5% annualized), but it could always use improvement.  For, as Goethe put it, “he who moves not forward, goes backward.” 

With that in mind, I’ve spent a lot of the last few months reviewing my investment process and looking for ways to improve.  One of the most important lessons I have derived is the importance of not investing in things that go down a lot.

Now, this may seem perfectly obvious to you, but it’s hard when one is busy with day to day research and portfolio management to focus on the downside instead of the upside.

In fact, I’d go so far as to say that most people focus too much on the upside–myself included.  Most people seem to believe that hitting the ball out of the park is the way to win baseball games, when in fact it has more to do with not striking out and getting base hits.

So it is with investing.  I’m a devoted fan of Warren Buffett, so this thinking should be more implicit in what I do.  Buffett describes his two investing rules quite simply:

  • Rule #1: don’t lose money
  • Rule #2: don’t forget rule #1

Or, as Alice Schroeder, Buffett’s authorized biographer, described it in a presentation at the University of Virginia: Buffett’s first step is to look for catastrophic risk.  If he sees any possibility of catastrophic risk, he just stops right there and moves on to other ideas.

I was struck recently with how little I’ve devoted to this side of the process.  How do you not lose money?  Don’t invest in things that go down a lot.  If you avoid blow-ups, then the upside will take care of itself.

Charlie Munger, Buffett’s business partner, likes to quote famed German mathematician, Carl Gustav Jacob Jacobi, on this issue.  Jacobi told his students to “invert, always invert” (the quote on Wikipedia is “man muss immer umkehren,” which I translate as “one must always invert”).  What Jacobi meant was that many problems can be solved backwards by inverting the problem.

For example, do you want to know how to be happy?  Instead of trying to figure out how to be happy by examining happiness or looking at what happy people do, look for what you absolutely know will make you unhappy and then don’t do that.  See the subtle difference?

If I study business successes, I may find out what common characteristics business successes possess, but that’s not the whole picture.  I must also look to see if business failures share those same characteristics to avoid hasty generalization.  Perhaps 5 businesses were successful by selling widgets and 95 were failures, so looking only at the 5 successes may lead me to falsely conclude that selling widgets is the way to success.  I must also study the failures to see the full truth. 

With that in mind, I can invert the problem as Jacobi suggests.  What causes businesses to fail?  If I know the answer well, and that business successes don’t do it, then I can avoid blow-ups by avoiding businesses with failure characteristics.  Invert, always invert, indeed.

So, not surprisingly, I’ve decided to become a student on what makes businesses fail.  By inverting the problem to avoid failures, I will ensure greater success in my investing results. 

Thank you Buffett, Munger and Jacobi.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Invert, always invert

My evolving investment approach

It’s interesting to note how my investment research process has changed over the years.

From the time I first read about value investing in 1995 up until 1998, my focus was almost exclusively on the numbers. Basically, I picked investments based on my assessment of the value of each business with a much lower emphasis on other factors (management, economics, product life cycles, etc.). I crunched the numbers and bought if something looked remarkably cheap.

From 1998 until 2001, my focus began to include a more thorough analysis of business economics. Here, my aim was to gain an in-depth understanding of the competitive advantages of each business and to what degree they were sustainable. This effort was much more qualitative than quantitative.

In 2001, I started to include a much more thorough analysis of management, too. For this, I looked at management’s tenure, their competence in the field, their compensation structure, their ownership of the business, the way that they talked to shareholders, etc. This, too, was a more qualitative effort.

What I’ve found is that you can never stop learning in this field (or in any other for that matter). Every year, I bring new elements into my analysis. Every year, I read books or articles that lead me to dig deeper into certain aspects of each business.

Although my general approach has remained the same–I look to buy underlying businesses, not stocks, and I try to buy them significantly below their assessed value–I continue to add more and more layers of analysis and experience on top.

I keep very good records of the investments I’ve looked at over time, both the ones I invest in and the ones I don’t. This has allowed me to review my past decisions and prevent sins of both omission (not investing) and commission (investing when I shouldn’t have) going forward.

I love my job, and I love learning more and more each year such that I can improve my expertise and, more importantly, my results going forward. And, as Charlie Munger and Warren Buffett have amply demonstrated, that’s a great way to build wealth and enjoy life.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Charlie Munger’s latest commencement address

For those of you who don’t know, Charlie Munger is Vice Chairman of Berkshire Hathaway and a hero of mine. Together, Munger and Warren Buffett run what I consider to be the best company in the world.

Munger recently gave a commencement address at USC Law School and someone present (Joe Koster) was kind enough to scribble notes of what was said. The speech is classic Munger: all over the place, thought provoking, no punches pulled.

Munger’s first comment was that the safest way to get what you want is to deliver to the world what you would buy if you were on the other end.

Next, he emphasizes how important it is to always be learning. Never accept where you are, be a learning machine.

He says a multi-disciplinary approach is a great aid to success. Venture outside your field, understand the most important ideas in as many fields as you can grasp.

He also mentions how useful it is to invert problems you are trying to solve. Instead of wondering what you need to do to succeed, consider what will certainly lead to failure–sloth and unreliability.

He suggests that you avoid extremely intense ideology. He warns that such an approach can lead to closed mindedness where new information isn’t honestly considered.

Don’t spend more than you make, he says. His example is Mozart, who was brilliant but miserable because he spent more than he made.

He says to avoid perverse incentives and associates. Both will lead you to do things you’ll later regret.

He suggest that you maintain objectivity by looking for disconfirming evidence like Darwin did. Most people only seek out confirming evidence, which can lead to confirmation bias.

With regards to people, he says you should pick the right people to be in important positions. Who are the right people? The learning machines with the aptitude and desire to never stop learning.

To be any good at something, you have to have an intense interest in it. This may seem obvious, but how many people chose to be doctors or lawyers because of the money instead of their interests?

Munger has a little fun with words when he says that assiduity is another key to success. Sit down on your ass until you do it. In other words, go to work until you get a thing done. Don’t make excuses, don’t whine, just do it.

Munger says not to suffer from self-pity. Things go wrong in life, and how you react to those things, whether fair or unfair, determines your success and happiness.

Munger suggests that he has done quite well in life anticipating trouble. It didn’t make him unhappy, and it made him ready to perform if trouble came.

His final idea is that a civilization built on trust (the kind you receive by earning it, not the kind you expect because you want it). Be the type of person who deserves trust, and you will benefit immensely.

Smart words from a very successful man. Thank you Mr. Munger, and Joe Koster.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.