Inverted Investing Strategy and The Importance Of Thinking Backwards
What You’ll Learn
- The importance of thinking and analyzing backwards.
- Common analysis mistakes made by investors.
- 5 inverted questions that will flip your analysis and thinking upside down.
I’m just your everyday Joe.
I put my pants on one leg at a time, did average at school and didn’t like to stand out in a crowd.
I also had a common dilemma.
I would spend hours going over sample math tests and solving math problems, but when exam day came, the question was worded slightly differently and it threw me off completely.
I sucked at application.
The thing is, if somebody, anybody, had introduced me to Carl Jacobi, it would have saved me a lot of heartache and I’m positive I would have gotten better grades.
Well, who is this Carl Jacobi guy anyway?
None other than the German 19th-century mathematician all-star. Unlike me, when Jacobi encountered difficult problems, he was fond of saying:
Invert, always invert.
Charlie Munger took the lesson from Jacobi and introduced it to value investors.
While math problems are less of an issue in investing, the multi-disciplinary approach is highly relevant and useful.
Investing is full of variables and problems that leaves me dumbfounded.
So what should a guy like me do?
Invert, always invert.
Common “Verted” Questions
One of the most common things you do when you approach a stock is to estimate intrinsic value in the long run.
- How much is it worth?
- How much will I make?
- How long will it take?
You can see how all these questions are forward-looking.
If the growth prospects are there, or if it looks like the next big thing, these questions help you jump onto the bandwagon.
E.g., it’s easy to join the mad dash with the hottest thing like the Social Media ETF (SOCL). After all, the Internet is only going to grow as more devices are used by people to be constantly connected.
You can’t possibly lose right?
Well, with every investment, there are two sides to the story, and the other side is what Jacobi and Munger want you to think about.
Invert, Always Invert. 5 Inverted Investing Questions
The purpose of investing is to increase wealth, right?
To do this, there are two main ways of investing.
- “Risk equals reward” style of investing where you go for risky bio techs hoping it jumps 1,000% upon FDA approval.
- Conservative style, by focusing on not losing money.
Guess which method Warren Buffett chooses?
Rule No. 1: Never Lose Money.
Rule No. 2: Never Forget Rule No. 1.
Unless you and I are trained, the most common way to think is the first option.
High risk = high reward. Go big or go home.
However, to get to Buffett’s playing field, it takes lots of trial and error to go from “How much can I make?” to “How do I not lose money?”
Same destination. Different road taken.
If you look at the 20 lessons that Seth Klarman learned during the 2008 crisis, you can see how he focuses strictly on minimizing and managing risk.
The Before and After of Going from Chasing Returns to Minimizing Risk
Looking back, my worst years have come when I didn’t stick to risk management principles and chased after big profits.
It blew up in my face.
Even the small possibilities of things going wrong, went wrong and I lost big.
After I started to apply better risk management principles
- my losses decreased
- my gains weren’t as volatile
- I slept easier at night
1. How can I lose money? vs. How can I make money?
If you focus on preventing the downside, you’ll be certain to make money. Outside of the stock market, this is how we operate.
We don’t buy houses at ridiculous valuations hoping to sell it to the bigger fool. We all want rock-bottom prices, because that’s how money is made.
So why does this logic get thrown out in the stock market?
2. What is this stock NOT worth? vs. What is this stock going to be worth?
If you can identify the floor price or a cheap price for a stock, it’s easy to make decisions.
If Apple (AAPL) dropped below $100, then I know it’s not worth less than $100, so I would scoop up more shares.
If the stock price is trading at $200 today, I know that the value is not worth $200, so I would sell.
Instead of focusing on the $300 stock price 10 years down the road where anything could happen, look at what the stock price is not worth, to make clearer decisions.
I used this simple logic to accumulate as many shares of Apple as possible where it’s now my biggest holding.
3. What can go wrong? vs. What growth drivers are there?
Rather than focusing on the growth and upcoming catalysts, first focus on the risks and the potential loss of money.
- What is the chance a big customer will leave?
- What happens if the Apple Watch is a flop?
- What can go wrong if the CEO dies?
- If the economy tanks, will the company be able to withstand cash flow difficulties?
4. What is the market implied discount rate? vs. What is a fair discount rate?
But before I answer that question, please click on the image below to get the best investment checklist that you can add to your investing treasure chest.
This is a specific question if you are using a DCF to value a stock.
My default rule of thumb is to apply a 9% discount rate.
However, if the market is applying a discount rate of 3% to the stock for its current stock price, it’s immediate that I need to do some more digging to see why it’s so low.
5. What is market-implied growth rate? vs. What is the future growth rate?
Rather than project a future growth rate, how much growth is the market currently attributing to the stock?
If the market is assigning a growth rate of 1% for Apple, I’ll be backing up the truck even more, because I don’t agree that the growth rate will be that low.
Instead of purely focusing on EPS projections and growth rates, look at what the current stock price is telling you, because there is a lot of information you can get.
Big Thanks Goes to…
Thank you, Charlie Munger, for teaching me to “Invert, always invert”. I just wish you introduced Jacobi to me back in high school.
What about you?
What inverted questions do you ask yourself?