Last Updated on January 17, 2023
Charlie Munger likes to think inversely. Inverse thinking simply means focusing on the things you don’t want to happen. Munger didn’t invent this concept, but he has made it immensely popular. (We recommend reading our article about Charlie Munger quotes.)
While Munger turns the question on its head, he touches upon a very important aspect: how to avoid mistakes. Why does inverse thinking help? Munger says inverse thinking avoids stumbling into trouble, mostly by doing fewer things wrong instead of focusing on doing more things right. Simply avoid or subtract things that do not work. Relevant inverse questions might be:
- How do I become a terrible investor?
- How do we make this company less innovative?
- What makes our products not valuable for the customers?
- How do I distract my work habits?
- How do I ruin my finances?
Asking such questions is of course a bit counterintuitive. Most investors focus on how to win, but perhaps it’s more fruitful to learn how to avoid mistakes. Victor Niederhoffer wrote the following in The Education of A Speculator:
There are so many ways to lose, but so few ways to win. Perhaps the best way to achieve victory is to master all the rules for disaster and then concentrate on avoiding them.
Inverse thinking can be of great help in financial decisions. For example ask yourself this: how do I lose money or how do I become a terrible investor/trader? If you want to know why something does well, then first study what does poorly.
In January 2017 Hendrik Bessembinder published a very interesting study called Do Stocks Outperform Treasury Bills? This is the main findings in his study:
- Only 42.1% of common stocks have a lifetime return that exceeds short-term treasuries from 1926 to 2015.
- About 50% of stocks deliver negative lifetime returns.
- The median (not average!) life of an individual common stock is only seven years.
- 96% of Monte Carlo simulations underperformed a value-weighted index, 99% underperformed an equal-weighted index and 72% underperformed short-term treasuries.
- In other words: the results are skewed to just a few stocks. Out of 26 000 stocks, just 86 were responsible for over half the value creation. 1000 stocks accounted for all wealth creation.
- Large capitalization stocks had much more staying power, and consequently a much better chance of beating Treasury Bills over a decade.
The findings are somewhat depressing. It explains quite well why most private investors fail in the markets (ample research shows this) either by overtrading or picking the wrong stocks. The results are a bit counterintuitive because we have been told that stocks have been the best asset class over the last century. Sadly and obviously, picking the right stocks over this period has been difficult, and hence a pretty good method NOT to generate wealth is done by investing randomly in individual stocks. As a group stocks perform well, but it’s extremely difficult to pick the future winners. The best choice is for most people to invest in a diversified mutual fund. If you do want to pick individual stocks, you must make sure you know what you are doing.
Is there a safer and easier way to financial wealth?
I believe real estate offers better odds. It’s not so exciting as the stock market and requires patience, but the chances of making mistakes are less because of more concentrated returns. Why is this?
- Stocks have a short life, but real estate usually lasts for decades and centuries (as long as it’s properly maintained). Even badly maintained, they last for a very long time.
- Apartments and offices “always” serve a need and demand.
- Real estate is a business model that is less likely to be disrupted.
- Available land is given and often in short supply.
- It serves as an inflation hedge. Rent can be passed on to tenants.
- Rent is basically “always” higher than the treasury bills.
One famous Norwegian real estate investor said ten years back that even lobotomized people can make money in real estate, and you must be pretty dumb NOT to make money. I believe the statistics are pretty compelling and explains where you are most likely to go financially wrong.
Of course, excessive leverage can ruin even the best plans.