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.