Words: 3,279 Time: 15 Minutes
- Invert your thinking to reduce your risk of loss
- First look down… not up
- What’s your investing goal (and philosophy) for 2025?
“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” — Charlie Munger
In life, part of the journey is making mistakes.
It’s how we learn. We learn to walk by falling over.
And getting things wrong can be a good teacher if you’re willing to learn from the experience.
However they can also be very expensive.
With respect to investing – our primary goal should be to eliminate (or meaningfully reduce) the possibility of making large costly mistakes.
A large mistake can reduce our investable capital – impacting our returns for years to come.
So how do we try to make fewer mistakes? There are two ways:
- You can choose to start at the bottom of the mountain by making every mistake from scratch on the way to the top; or
- You can choose to take a sherpa with you and master the best of what other people have already figured out.
I choose the latter – learning from mistakes that people like Charlie (and others) have already figured out.
But here’s the best thing:
It costs you nothing to collect other people’s mistakes and learn from them.
Not many things in life are free. Collecting others mistakes are.
As I started investing in my 20’s – I tried climbing Mount Everest (sticking with the metaphor) alone without a sherpa or map!
Needless to say, it was a case of making costly errors (especially during the dot.com crash of 2000).
Everything I owned more than halved in value… and some stocks went into Chapter 11.
My only piece of good fortune?
I was young.
It’s best to make big (costly) mistakes early in life.
These days I’m not interested in climbing mountains alone.
But very successful people know this already.
They are vicarious learners and typically read a great deal (here’s a short list of books to get you started).
In that sense, knowledge is not unlike money. It compounds over time as you add to it.
Foolish people on the other hand choose to read very little (or not at all)
They choose to insist on first-hand pain – climbing the mountain solo – willing to make every (expensive) mistake along the way.
Like most things in life – this is a choice.
Learning from others – and avoiding the mistakes they made – was core to Munger’s investing (and life) philosophy.
Charlie passed away just over a year ago at the age of 99 – merely 4 weeks before his 100th birthday (see “Charlie: More than a Brilliant Investor”).
The billionaire investor said avoiding mistakes in business (and life) comes down to three simple things:
- Good financial habits;
- Acting with integrity; and
- Avoiding toxic people and toxic activities
On good financial habits, Munger said that people are “almost certain to succeed” if they:
- Spend less than they earn;
- Invest shrewdly;
- Learn continually; and
- Remain disciplined
Without those traits, you’ll need a lot of luck “climbing the mountain” of life.
I can’t help you with spending less than you earn (that’s a lifestyle choice) – but this blog is firmly grounded on investing shrewdly; learning continually; and applying rigor and discipline with every decision.
Let’s start with why inverting your thinking is so important…
Invert to Avoid Making Mistakes
“Invert. Always invert. This is a great way to avoid making stupid mistakes”
“For example, let’s say you have the problem of ‘how to get more customers’. The inversion of this problem is asking “how do I make our customers hate our products?”
The answer will be all things you must absolutely not do – which will help you avoid making (basic) errors”
Charlie is saying a lot of advantage can be gained simply by avoiding the standard paths to failure.
However, when it comes to investing or asset speculation – inversion is not how we naturally think.
For example, when buying an asset, people will naturally want to “look up”; i.e., thinking of the possible gains (more on this further below)
They might say “I want to make 15% per annum” or some arbitrary figure.
However, the better approach is to start by “looking down“; i.e., what could I possibly lose by making this investment?
2% of my portfolio? 10%? 20%? What if things go wrong? What things have I assumed?
We’re programmed to identify what we want and explore things that will move us closer to our objective.
For example, while you may want to average a “12% to 15% yearly return” on your investment (a lofty goal) – it’s the wrong lens.
Instead we should be less consumed by the end result. It will look after itself.
What we should be focused on is identifying and avoiding things that will ensure we don’t get what we want.
For example, that could be buying stocks that:
- Trade at extremely high multiples relative to their average (or longer term mean);
- Exhibit excessive debt to equity ratios;
- Failure to show a strong return on invested capital over time;
- Don’t have the ability to meet short-term interest payments from operating free cash flow; or
- Show a consistent record of negative free cash flows etc.
This list was not intended to be exhaustive.
However, by avoiding these (and similar) attributes – we can increase our odds of success.
By adopting the lens of inversion – it forces us to consider the opposite side of the equation.
For example, instead of asking “how much can I make”... applying inversion will ask something like “what would increase my chance of failure?”
Paying too much for a stock will increase your odds of failure.
By inverting the question, we are then able to open insights that our ‘default’ thought patterns might miss.
Let’s explore this powerful mental model further (as it applies to your investing approach).
What’s Your Investing Philosophy?
Warren Buffett likes to say that the first rule of investing is “don’t lose money”.
The second rule is “never forget the first rule.”
That’s a great example of inversion.
Buffett is starting from a position of not losing money vs how much money he could make.
You have never heard Buffett stand up and say “next year we hope to make 20% on our capital”.
But how often will the average investor set some number as the goal?
I personally believe loss aversion should be every investor’s highest priority.
We should always start by looking through the prism of what could go wrong; any aggressive assumptions made; and overall risk exposure.
But let me clarify….
Adopting such a mindset with investing does not mean that investors should never incur the risk of any loss at all.
No…
Rather “don’t lose money” means that over several years (e.g., generally up to four or five) — an investment portfolio should not be exposed to appreciable loss of principal.
Consider where the S&P 500 trades today at ~22x its forward earnings. From a historical context, that is:
- 32% higher than its 100-year average of ~15x forward earnings; and
- 22% higher than the trailing 10-year average of ~18x forward earnings.
Therefore, assuming mean reversion to the trailing 10-year average – we could easily see a 22% move lower.
That’s what you could potentially lose.
Now we can’t predict the future (more on this shortly) – but it at least helps frame your potential loss of capital.
And from there, this will influence what capital you choose to put at risk.
Obviously no-one wishes to incur losses.
However, as we watch stocks which trade in areas like AI, crypto, cyber-security or quantum computing – the speculative urge is strong.
When that urge takes hold – they’re happy to pay almost any price for possible gains.
And therein lies the rub…
The prospect of catching the next “Amazon” or “Nvidia” can be extremely compelling – especially when we watch their prices skyrocket.
For example, barely a week goes by when someone writes me and says:
“Adrian, are you buying Tesla? Did you buy Nvidia on the dip? Are you getting into crypto” … and on it goes.
But notice what’s missing…
These readers are not concentrating on potential losses.
What they’re doing is the inverse; i.e., entirely focused on reaching for gains.
For example, they see some popular name well off its near-term highs – and they start thinking about what gains they could make on any rebound.
But it’s the opposite of what you should be doing….
For example, a more thoughtful email might read:
“These are quality financial ratios I’ve figured for “Tesla “(e.g. its 10-year average (and TTM) for ROIC, ROE, ROA, FCF, D/E etc) – and here’s its current valuation – 45x forward earnings – what do you think? This is the intrinsic value I calculate for the stock. Is this at risk of major loss? What growth assumptions should we make? “
But that’s a far more difficult to email to write…
It requires a lot of time and work to figure these numbers. It also requires thought assessing the downside risk(s).
However, that’s where we should start.
Focus First on “Looking Down”
Echoing Buffett and Munger (and others like Howard Marks, Seth Klarman, Stan Druckenmiller, Joel Greenblatt, John Neff, Sir John Templeton, Walter Schloss, and Philip Fisher. etc) – the avoidance of loss is the surest way to ensure a profitable outcome.
This is what they (and others) are religiously focused on.
However, it’s largely at odds with today’s investing zeitgeist (see this post “Buying is Easy – Selling is Hard”; and “Trees Don’t Grow to the Sky”)
Yes, it’s true that stocks have proven to outperform every other asset class over the time (e.g. the past 50+ years)
That’s not what we are debating…
Instead what we’re seeking to highlight is the risk of a particular investment depends entirely on the price paid.
It doesn’t matter what the risk asset is.
It could be stocks, property or bonds. If you overpay for the asset – you’re at risk.
What happens with risk assets is some investors will continue to bid up prices up to a point where they no longer offer superior returns.
And that’s what I think the primary risk is today (especially in popular names – mostly those in the S&P 500 and specifically the Mag 7)
The risk of loss is exacerbated by paying a higher price.
Risk Avoidance is Not Incompatible with Success
Another common belief is that risk avoidance is incompatible with investment success.
This is a misnomer.
This view holds that higher returns (e.g., 15%+) is attainable only by incurring higher risk.
And further to that – long-term investment success is attainable only by seeking out and bearing, rather than avoiding, risk.
I don’t subscribe to that logic.
Again, let’s put this logic to a simple test:
- If you had $1,000, would you be willing to wager it, double or nothing, on a fair coin toss?
- Would you risk your entire net worth on such a gamble?
- Would you risk the loss of, say, 30 percent of your net worth for an equivalent gain?
In each case, most of us would answer “no”.
Very few people would take these bets because the loss of a substantial amount of money could impair their standard of living – while a comparable gain might not improve it commensurately.
If you are like me and answered no to each of these questions – you are risk averse.
Therefore, loss avoidance should be the cornerstone of your investment philosophy.
It should not be chasing greedy (fear of missing out) short-term gains.
But let’s come back to the impact of a heavy loss — and what it does to your long-term returns (something I touched on recently in another post).
The effects of compounding even moderate returns over many years are extremely compelling (see this post on Buffett’s record vs the S&P 500)
For example, compounding small amounts on $1,000 (e.g. just an incremental 2% per year) over time can have a mind-boggling impact:
| 5-Years | 10-Years | 20-Years | 30-Years | |
| 6.0% | $1,338.22 | $1,790.84 | $3,207.13 | $5,743.49 |
| 8.0% | $1,469.32 | $2,158.92 | $4,660.95 | $1,0062.65 |
| 10.0% | $1,610.51 | $2,593.74 | $6,727.49 | $1,7449.40 |
| 12.0% | $1,762.34 | $3,105.84 | $9,646.29 | $29,959.92 |
| 16.0% | $2,100.34 | $4,411.43 | $19,460.75 | $85,849.87 |
| 20.0% | $2,488.31 | $6,191.73 | $38,337.59 | $237,376.31 |
For reference only, Warren Buffett has doubled the S&P 500 total return – averaging ~20% pa for 57 years.
This translates to a 3,641,613% return over this period vs 30,209% for the S&P 500.
However, it highlights an important point:
Modest and sustainable rates of return are of the utmost importance in compounding your net worth.
And these returns don’t need to be “20%” like Buffett (where very few (if any) investors have achieved anything higher over this length of time).
Personally, averaging say 12% is a very solid result over 20 years (it would beat the market).
If you can achieve 15% for more than 10 years – then you are in truly elite company.
However, a corollary to the importance of compounding is that it is very difficult to recover from even one large loss.
The effects of compounding will evaporate – sending you back many years.
This is the key takeaway from this missive….
We want to avoid a loss which could literally destroy all at once the beneficial effects of many years of investment success.
It reminds me of the old saying: “it takes three to four generations to build wealth; and just one generation to destroy it”
For example, I know many readers experienced crushing 30%+ losses during 2022 (mostly those with over-exposure to tech)
Fortunately, the past two years have helped many recover some of those drawdowns.
But it should serve as a valuable lesson…
What this shows is an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal.
I look at my own track record…
Over the past decade – I’ve been able to generate returns of around 14 percent annually.
Again, modest and sustainable consistent gains.
However, if I compare that to the S&P 500 Index, there were years where it posted near ~30% gains; and others where it gave back ~20% (e.g. 2022).
But what seems to appeal more investors is taking excessive risk to deliver “outsized gains” (despite the risks).
Why?
To that end, I think this explains why risk avoidance is not the primary focus of most investors (which includes institutions).
Can You Predict the Future?
Over the 15 years writing this blog – I’ve gone to lengths to highlight how most experts fail with forecasting.
I call it a fool’s errand.
For example, with respect to predicting how 2024 would end the year – J.P. Morgan were out by 40% (and they were not alone).
And in terms of forecasting what will happen with the general economy – the Fed are not much better:
- Alan Greenspan didn’t see irrational exuberance in 1999;
- Ben Bernanke didn’t see anything speculative in housing in 2007 (e.g., forecasting 2.5% GDP for 2008 and stable employment); and
- Jay Powell told us in 2021 that inflation was simply transitory.
Neither the ‘CEO of JP Morgan’ or any ‘Chair of the Federal Reserve Bank’ (or anyone in the financial media) can tell you with any certainty the following:
- If the economy will shrink or grow (or how fast);
- What the rate of inflation will be;
- Whether interest rates will rise or fall; or
- What the stock market will do in 1 month, 3 months, 6 months or 12 months etc.
But knowing what we don’t know helps us to help reduce the risk of blind spots.
For example, an investor who is prepared for such events will position themselves to survive should bad luck strike and in the event of mistaken judgement.
We may only have one or two economic depressions or financial panics in a century – but such events can (and will) occur.
For example, I believe I will see another 4-5 recessions before my investing career is done (~30-40 years).
Based on this – this means foregoing some near-term return.
For example, I underperformed the market by 11% last year as 35% of my investable capital sat in cash and/or short-term t-bills (earning ~4.50%).
Now if I was running a fund – most (impatient) people would head for the exits (irrespective of the 10-year 14% CAGR) – based on last year’s returns.
However, I treated the ~35% in cash as my insurance premium against unexpected and unpredictable adversity.
Fortunately I didn’t need it – but unlike others – I could not be certain.
The “How” Is More Important than the “What”
We are almost at the end of this missive…
However, it’s important to note that choosing to avoid meaningful loss is not a complete investment strategy.
For example, a loss-avoidance strategy does not mean that investors should invest “50%” of all their assets in “gold and treasuries” (and hide in some bunker!)
Not at all…
That’s not the intent.
For example, if choosing to minimize the risk of substantial loss – I say it’s ‘incomplete’ in the sense it will not tell you:
- What to buy and sell?
- What risks are acceptable vs those which are not?
- What position sizes to take?
- What balance of fixed income vs equities to take? etc
More accurately, avoiding a meaningful loss of capital means being prepared for the fact the world can change unexpectedly.
And if it were to change – what’s your exposure?
What assets do you hold and what did you pay for them?
Again, look at Chairman Bernanke’s view of the world in 2007….
One year later the world was a very different place. But how many investors saw it?
Therefore, if you’re an investor who sits down and simply says “my goal is to make 15% per year via a diversified ETF and holding it for 10+ years “ – you should think about shifting your lens.
Setting these kinds of outcomes does not make that return achievable.
The outcome is what I like to call the “what”. But what investors should be focused on is the “how”.
Stating that you want to earn “xx% percent a year” does not tell you a thing about how to achieve it.
For example, your investment returns are not a direct function of how long or hard you work or how much you wish to earn.
An Uber driver may work additional hours for more income.
However, an investor cannot decide to think harder or put in overtime researching cash flow statements and balance sheets over the past 10+ years in order to achieve a higher return (if only!)
What an investor can do is double-down on the how (and forget about the what)
That is, follow a consistently disciplined and rigorous approach.
If you follow a sound process – then over time – the returns will look after themselves.
Putting it All Together
Charlie Munger has been instrumental in helping me develop a lattice of mental models to think through problem solving and investing.
For me, one of the most impactful tools was to always invert my thinking.
I start by looking down (not up)
Don’t set arbitrary outcomes like “I want to achieve xx% per year” – forget about that – you will lose sight of the risks.
Instead focus relentlessly on the how.
As an aside, something I often see is people mistaking good outcomes with good decision making.
Sometimes we will enjoy good outcomes from poor decisions. That’s called luck.
What’s more important is applying good decisions – a robust framework – regardless of the short-term outcome.
I hope this post gives you food for thought as we head into an incredibly unpredictable year.
From mine, stocks are as expensive as I’ve seen them in ~25 years.
Based on this, the risk has rarely been higher.
That’s not to say they may not rise further – they could – momentum is a powerful force.
However, when the tide shifts, ensure you’re well positioned.