Your Portfolio Is Doomed Without This Crucial Skill

Charlie Munger famously said:

“All I want to know is where I’m going to die, so I’ll never go there.”

It’s a simple premise.

You can solve many of your problems by addressing them backward.

The benefit of this approach became clear to me when I came across Munger’s commencement speech at Harvard University in 1986. You can find transcripts online under the name “How to Guarantee a Life of Misery.”

In his speech, Munger discussed three things in life that will make it miserable:

1. Do drugs.
2. Be envious.
3. Show resentment.

He went on to cover four more prescriptions that guarantee our failure:

• Be unreliable.
• Learn everything yourself (from your own experience).
• Give up early.
• Don’t invert.

Inverting, he explains, is the study of how to create X by turning the question backward, by studying “how to create non-X.”

The German algebraist Carl Gustav Jacob (Jacobi) famously solved complex problems following this simple strategy: “man muss immer umkehren,” which you’ll find translated as “invert, always invert.”

This idea is a recurring theme in many of Munger’s interviews and speeches:

“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.”

Avoiding stupidity is easier than seeking brilliance, he explains.

We can find many examples in our lives where defining what we don’t want and avoiding it can lead to better decisions.

For example, how to have a successful marriage?

We all might have different opinions of what success might look like, and some partners might disagree.

So let’s invert this question: how to get a divorce?

Now we can look at the most common reasons why people get a divorce.

Let’s cover some possible answers:

• Cheating.
• Being abusive.
• Marrying too young.
• Substance addiction.
• Being unreliable/absent.
• Causing financial distress.

Since more than half of marriages end up in divorces, many people fail to avoid these familiar patterns.

There is usually more to lose on the downside than to gain on the upside. Some decisions may be too harmful to be offset. For example, no matter how great of a partner you might be, cheating once or being physically abusive once may be enough to end a relationship.

Avoiding harm is immensely important because it can be hard or impossible to offset harmful things. Only one mistake can doom an otherwise well-thought-out plan.

Inversion is a crucial skill that can help us avoid single points of failure, which is particularly important regarding family, health, and wealth.

• No one gets married with the intention of getting a divorce.
• No one starts investing with the intention of blowing up their portfolio.

Yet, so many people do.

In his book The Money Game, George Goodman explained:

“If you don’t know who you are, [the stock market] is an expensive place to find out.”

Without defining the single points of failure you need to avoid, you’ll likely learn costly lessons and potentially lose your ability to stay in the game.

So today, I want to cover ways to apply inversion to personal finance and investing by asking how to achieve the opposite of what we want.

How to make sure our portfolio is doomed?

Let’s dive in.

How can you destroy your financial health?

We all want to be wealthier.

So what if we invert the question?

What is the surest path to destroying all our financial goals?

• Spending more than we earn.
• Accumulating short-term debt.
• Losing all our money gambling.
• Not having enough money for emergencies.
• Withdrawing early from our retirement account.
• Compulsively spending money on things we don’t need.
• Relying on only one source of income for our entire household.

These examples are obvious points of failure we would want to avoid.

You are already ahead of the pack if you can avoid these problems.

In their book, The Millionaire Next Door, Thomas Stanley and William Danko separate individuals into three categories:

1. Under Accumulator of Wealth: Low net worth compared to their income.
2. Average Accumulator of Wealth: ~1/10th of their age multiplied by their current annual income.
3. Prodigious Accumulator of Wealth: Well over the average.

The book covers many examples of under-accumulators of wealth. It’s not about their income. It’s about how much they spend relative to how much they earn.

Under-accumulators tend to own nice things. They live in large houses and buy foreign luxury cars or boats. It all comes down to spending habits. A $50,000/year janitor can be more of a prodigious accumulator of wealth than a $700,000/year doctor.

So how to be an under-accumulator of wealth? Simple. Increase your lifestyle every time you increase your income, and assume you’ll always make more.

Starbucks lattes and avocado toasts are not going to destroy your wealth. However, the big-ticket items (car loans, mortgages, rent) and lifestyle decisions generating recurring costs will make a dent.

You can destroy years of retirement with a bad car shopping habit. You can put your family in a precarious position with a single decision around where you live and the cost of your mortgage or rent. These potential single points of failure should help narrow your focus where it counts.

You are unlikely to become a prodigious accumulator of wealth if you don’t know what comes in and out of your bank account every month.

A fundamental part of the success of an investment portfolio is how early in your life you start and how much you contribute to it.

Until you have been investing for 20+ years, the amount you save probably matters more than your returns. I cover this topic in more detail in secret #10 of my 10 Investing Secrets I Wish I Knew When I Started.

What will be the costliest investment decision?

Personal finance is an essential step, but let’s shift to investing.

What are the most significant investing mistakes we’ll make?

The kind you regret for the rest of your life?

I wrote previously about The Art of Not Selling and explained why the mistakes that most impact your performance are likely to be decisions to sell too soon.

While the maximum you can lose is 100% of your investment, the gains are uncapped. So as long as you manage a diversified portfolio with reasonable starting positions (more on that later), the decisions that will alter your long-term performance are sell decisions.

With this in mind, to invert, I would ask:

• What is leading us to sell too early?
• What makes us trim a position that we should leave alone?

The answer? Emotions!

The single point of failure for our portfolio is ourselves. We get in the way of our own success.

Peter Lynch explained:

“The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.”

You can borrow ideas and opinions, but you can’t borrow conviction. So the most helpful tool in the arsenal of the long-term investor is to build a strong understanding of the fundamentals of the businesses held in a portfolio. That’s the only way you can feel at ease when a portfolio inevitably underperforms, or a stock suffers a significant pullback.

One way to stay grounded is to document our process and know why we invested in the first place.

We have a natural tendency to trade too much. Sitting on our hands and watching a position evolve organically over time can be excruciating.

Many events can trigger the temptation to tinker with a position. However, it’s essential to recognize that there is rarely a call to action.

It’s in our nature to look for excuses to sell an investment not performing in line with our expectations. We obsess over price movements and sell to secure our gains or to avoid further losses.

There are many ways to alleviate this, such as leaning toward inaction.

Warren Buffett explained in a 1990 shareholder letter:

“Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings.”

He added in 1996:

“Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market.”

Yes, buy and hold is undefeated as an investment strategy.

Alternatives tend to rely on luck, high fees, or be tax inefficient. Buying and holding great businesses is a process that is sustainable and replicable over time and only requires us to be right once (when we buy).

I know, I know. There are many examples of successful traders. But there is a great deal of survivorship bias.

In a previous article, I explain the benefit of the Coffee Can Portfolio and expanding our time horizon. We can stack the deck in our favor by adjusting our process.

I like to say that selling should only occur under two circumstances:

• I need the money.
• The thesis is broken.

You see, success is not linear. If you part ways with your shares at the first sign of a business deceleration, you’ll never be able to hold an investment over multiple cycles. Every two or three years, an inevitable slowdown will occur. It’s precisely holding through these periods of doubt that give you a chance to find a massive winner in your portfolio one day.

Holding for years on end is necessary but not sufficient.

Ultimately, big winners are a rarity. It’s a numbers game.

How do you ruin a portfolio?

You have probably heard of the three L’s from Warren Buffett:

“My partner Charlie says there is only three ways a smart person can go broke: liquor, ladies and leverage. Now the truth is — the first two he just added because they started with L — it’s leverage.”

People don’t go broke with a diversified portfolio of great businesses.

They go broke when they gamble.

Leverage is one of those strategies that works great until it doesn’t.

The rule here is simple. Don’t do it!

You’ll never get a margin call if you never borrow money to own stock.

Don’t get me wrong. I’m well aware that there are many intelligent and prudent ways to use options. However, staying away from leverage guarantees that you won’t be able to do irreversible harm to your portfolio.

If you find any method that can accelerate your gains, remember that it can accelerate your losses just as much. There’s no free lunch.

Now let’s talk about diversification.

The idea of a concentrated portfolio comes from Buffett himself. After all, he likes to say ‘diversification is protection against ignorance.”

As of August 2022, Buffett had 73% of his equity portfolio at Berkshire Hathaway (BRK.A) (BRK.B) in his five largest holdings:

• Apple (AAPL) 42%.
• Bank of America (BAC) 10%.
• Chevron (CVX) 7%.
• The Coca-Cola Co. (KO) 7%.
• American Express (AXP) 7%.

The problem is that many investors take this idea as a justification to run an overtly concentrated portfolio with huge initial positions in companies that have yet to prove themselves.

I’m sorry to break it to you. You’re probably not the next Buffett. I’m not, either. Instead, I’m happy to claim the title of ‘master ignorant,’ and I would rather own dozens of stocks.

Brian Feroldi encapsulates this idea well in the tweet below.

In the past 20 years, owning Amazon (AMZN), Netflix (NFLX), or Alphabet (GOOG) (GOOGL) would have been enough to achieve all your financial goals.

How many stocks should you own? I previously tried to answer this question in a specific article, and the correct answer will be different for every investor.

Some investors take great pride in selecting only five to ten stocks and watch them closely. However, watching a stock closely won’t turn it into a winner. And all investments need years for their story to play out. So with a very concentrated position, there is always a risk of having a large portion of a portfolio in a precarious situation, leading to turnover, tax inefficiencies, and rushed decisions.

Again, the key is to invert. So how do you ruin a portfolio? By using leverage or making unnecessary concentrated bets in stocks that don’t work out.

Having too many positions is not a single point of failure. Too many stocks may eat away at your alpha, but it won’t blow up your portfolio.

What is a poor investment selection?

I previously offered 10 Reasons Not To Buy A Stock.

At the time, I was applying inversion to define what I didn’t want to see in my portfolio:

1. Poor unit economic.
2. No economies of scale.
3. Negative return on invested capital.
4. Poor Glassdoor rating.
5. Poor trailing stock performance.
6. Free cash flow to debt is below 25%.
7. The business is in secular decline.
8. It’s a penny stock.
9. You don’t really understand the business.
10. The company is not aligned with your values.

These qualitative filters are handy for me to say “next!” quickly every time I come across a new investment idea.

Consider this:

• The S&P 500 (SPY) alone includes 500 companies.
• There are more than three thousand companies trading on the Nasdaq beyond the Nasdaq 100 (QQQ).
• You can invest in thousands more stocks worldwide.

So if you are only going to invest in a few dozen, you need to be able to filter out the weeds.

Let’s face it. Most stocks are not worth your time and energy, let alone your hard-earned money. If I spend a day researching a company, I’ll never get these hours back.

Peter Lynch likes to say:

“The person that turns over the most rocks wins the game.”

If you want to turn over a lot of rocks, you need to recognize what kind of rock is not going to cut it. You’ve probably heard of Munger’s “too hard” pile. In addition, I also use a “not good enough” pile that would include stocks with some of the traits mentioned above.

Meme stocks like GameStop (GME) or AMC (AMC) would not make the cut in my selection because they would fail the above test.

It always makes me sad when I see sound investing principles applied to the wrong kind of assets. For example, if you invest in a business in secular decline, holding for the long term won’t help you.

The beauty of safeguards

Let’s round up how we can avoid single points of failure in our investing process.

Do you have safeguards in place that will prevent you from going “all in” or letting your emotions take over?

Your performance as an investor depends primarily on what you do during periods of high volatility. As a result, using a systematic investment strategy can be a powerful tool.

I use 4 Simple Rules to protect my portfolio:

1. I invest a fixed amount monthly (consistency).
2. I don’t add to losers (fighting prospect theory).
3. I don’t sell winners (staying the course).
4. I invest for no less than five years (time horizon).

I get to decide every month which stocks represent the best opportunities based on fundamentals and valuations. Still, the day I invest and the amount I invest are already pre-determined based on my rules and process.

These safeguards make my investment journey incredibly easy to maintain in all market conditions. And it helps me keep a balanced approach under all circumstances:

• It limits the maximum amount I can add to an individual stock (diversification over several positions).
• It forces me to invest every month of the year, even when everyone else is in panic mode.
• It limits the total amount I can invest in a single month, easing my way in the market (spreading investments over time).
• It keeps me invested through the vicissitudes of the market.

In his book The Psychology of Money, Morgan Housel explained the difference between being rational vs. reasonable. A rational decision means making a decision strictly based on what the facts and the numbers say. It all sounds great in concept. The implication is that you let the data decide for you.

However, being rational is not always a realistic approach. We all have emotions at play that can get in the way of a sound plan. Sometimes, what would make the most sense for you will differ from the most rational decision. So, instead, you need to define what is reasonable for you.

The proper diversification is the one that keeps you in the game over multiple market cycles. That’s why portfolio suitability is so essential.

Once you have defined a plan that suits you and have an automated system to keep it in place, you are unstoppable.

Bottom Line

Inversion can be counterintuitive.

When we invest, we think more about what we want than what we should avoid. Yet, inversion is an essential tool that has served legendary investors such as Buffett and Munger well. Effective investors consider complex problems by thinking about them forward and backward.

Inversion can become particularly beneficial for challenging your established beliefs. For example, maybe you are using leverage, investing money you don’t have, or taking large concentrated positions in unproven businesses.

• Have you considered what could happen if you are wrong?
• What would it take for you to miss your financial goals?

Inversion can help you find the right balance and guide you toward a reasonable portfolio. A portfolio you can maintain through multiple cycles without facing a single point of failure.

What about you?

• How do you create safeguards to stay on track?
• Do you apply inversion in your investing strategy?
• What are examples of things you avoid at all costs?

Let me know in the comments!