Charlie Munger, Warren Buffet’s famed right-hand man at Berkshire Hathaway, is fond of using the phrase, “Invert, always invert.” While Munger is often credited with the origination of the quote, he is borrowing from 19th century German mathematician Carl Jacobi, who coined the phrase as a means to capture how he felt many difficult math problems were best handled: by turning them on their head and working backwards toward a solution.
One way that you can apply this inversion technique is by looking at an outcome which is the opposite of what you want, and then figuring out what steps would lead you to that outcome, thereby avoiding them at all cost. This technique is especially useful in investing, which, as Charles Ellis wrote, is like a tennis match between amateurs: the winner is not the one who hits the most “winners” but rather the one who makes the fewest mistakes, the fewest unforced errors.
But before we can apply this technique to our problem, we need to say something briefly about the outcome we want from investing, which is that it would maximize our lifetime of saving, so that we can provide for specific and meaningful experiences with people we love even when we’re not working. The shorthand for that is, “successful investing is meeting your financial objectives,” but it’s important to remember that those “objectives” are representative of real people and real meaning.
The opposite outcome from the one we want, then, is to not be able to meet our financial objectives. That failure could be one of degree (not getting to do as much, or as soon, or as long as we hoped) or it could be total (running out of money).
Now let’s invert. What are three ways we can fail?
Failing Slow, Failing Fast, and Failing Very Fast
I came across these concepts from the guys at Newfound Research a couple months ago and loved the idea of couching investing failure in terms of speed. Let’s take a look at each:
- Failing Slow. This type of failure is essentially the idea of getting beat by inflation. It is failure that’s not sudden or event-driven, and the degree of failure it leads to is not likely to be total (i.e. running out of money), but it is guaranteed if you’re not careful. Generally this slow failure is the result of keeping too much cash (which has negative real returns over time) in your portfolio, or not being willing to invest in equity assets that earn a risk premium over time, or even eroding your returns with high fees and taxes. But you could also think of this failure in terms of lifestyle inflation. Those whose savings do not keep pace with their lifestyle creep will likely fail slowly, even if they are taking more optimal risk.
Lesson: Make sure your investment allocations and the risks therein are appropriately tied to your financial objectives rather than sitting on piles of cash and hoping for the best.
- Failing Fast. This type of failure is exemplified by sudden, large losses that occur at really bad times (i.e., when you’re actually spending from assets in your portfolio). This is often known as “sequence of return” risk and is especially devastating to those nearing or just entering retirement. Generally it’s the result of having too much of your portfolio in equity assets or having your equity risk be under-diversified, because you’re at a stage where the volatility of those assets works very much against you (as opposed to when you’re saving).
Lesson: Make sure your investment allocations and the risks therein are appropriately tied to your financial objectives rather than sitting on too much risk and hoping for growth you don’t need anymore.
- Failing Very Fast. This one is all about behavior. Failing very fast is the result of making poor decisions at bad times, often compounding one of the two types of failures above. Maybe you realize you haven’t saved enough or haven’t taken enough risk, so then you pile into risky equities right before a big correction. Or maybe the risk in your portfolio turned out to be more than you could stomach so you sell right at the bottom of a crash, pull everything to cash, and miss the entire come up. And in between those are a multitude of other decisions you could make about a rental property, a “hot investment,” cryptocurrencies, being undiversified–you name it!–that can spell disaster for you.
Lesson: Have a planning process that you can stick to, and have a trusted advisor to help keep you from making bad decisions in the heat of the moment.
So now we know three ways–and three speeds!– to fail. If you avoid each of those at all costs, you will be well on your way to succeeding as an investor. And don’t forget what that success is: It’s not an account balance, it’s not your returns, it’s definitely not based on someone else’s definition–it’s the ability to have specific and meaningful experiences you define with people you love. That’s it. Let’s make it happen!