Invert, Always Invert
January 8, 2024
Author: Jason Kirchhoff
In November the investing world lost one of its icons. Charlie Munger was an investor, businessman, and philanthropist but he will likely be remembered most for his mental models. He had an uncanny ability to distill years of acquired wisdom into short aphorisms. In honor of Mr. Munger, I would like to focus on just one of his famous sayings…
“Invert, always invert: Turn a situation or problem upside down. Look at it backward…”
The stylistic chart below highlights the problem/situation that we face when we construct portfolios to meet financial goals. The dotted blue line represents the value of a portfolio up until today and the multi-color lines on the right represent the possible outcomes in the future.
The common approach to uncertainty about the future is to reduce ambiguity by reviewing economic data (unemployment, GDP growth, interest rates, inflation, etc.) and predicting a path for financial markets going forward. The predictions will seem reasonable and intuitive but unfortunately, the track record of economists successfully predicting the future is underwhelming, to put it mildly. In addition, if a prediction is consensus, it is by definition already built into the prices of asset markets and not very helpful to investors.
Instead of building a portfolio around likely erroneous predictions, we can invert the problem by focusing our thinking on what could go wrong. This approach prioritizes capital preservation and tilting away from areas that can erode wealth over time. We increase the resiliency of portfolios to many different outcomes rather than trying to predict or guess at the future and build a portfolio that will do well in one specific environment.
Let’s look at a couple of examples of what the “inversion” approach looks like in real life. The following three critical risks can have a significant and long-lasting impact on portfolio values and are good examples of where something could go wrong.
- Inflation – Inflation has been muted for decades due to globalization, cheap energy, and demographics but these secular trends won’t always be in place. Inflation can hurt portfolios in many ways from a straightforward loss of purchasing power to increased volatility due to an increased correlation between traditional asset classes.
- Geopolitics – We prefer to have a globally diversified portfolio, but history shows us that the risks of investing in a country with limited rule of law can sometimes lead to irreparable losses and the permanent impairment of capital.
- Valuations – Asset classes go in and out of favor with investors and therefore the multiples that investors are willing to pay for future cash flows go up and down as well. From a risk perspective, high valuations typically reduce the margin for error of an acceptable outcome for investors and the opposite is true for low valuations. These valuation cycles can last years and things that are expensive can get more expensive. Tilting portfolios towards cheaper asset classes can provide a cushion against unforeseen events.
We can't eliminate our exposure to these macro risks, and we can't predict the timing of when they will matter but we can build portfolios that seek to partially mitigate these risks.
Focusing on what could go wrong means we won't impress you with our intelligence and predictive abilities, but we think the tradeoff is a more durable approach that will help increase your likelihood of achieving successful outcomes and improves your ability to meet financial goals. Once again Charlie Munger has a pithier way of saying the same thing…
“Everyone is trying to be smart, I’m just trying not to be stupid.”
The opinions expressed are those of McGill Junge Wealth Management as of the date stated on this communication and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.
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