Charlie Munger (Trades, Portfolio), Warren Buffett (Trades, Portfolio)'s right-hand man, once said, "All I want to know is where I'm going to die, so I'll never go there." His thinking on this matter was inspired by German mathematician Carl Gustav Jacob Jacobi.
Jacobi believed that the best way to solve complex problems was to look at them backward. "[Jacobi] knew that it is in the nature of things that many hard problems are best solved when they are addressed backward," Munger once stated.
Every investor can benefit from this approach, not just in investing but in life as well. I firmly believe that the inversion principle is one of the best ways to learn, develop and grow as an investor.
Common mistakes
A great method to learn and grow as an investor is to look at case studies. Studying the successes and failures of others is an excellent way to build our own processes and learn which strategies to avoid and which to follow.
However, while this process does have its benefits, it has its drawbacks as well. It is very easy to look at the careers of other investors and think they made all the right choices. That is usually not the case. Rather than trying to copy what they did right, we should be asking ourselves what they didn't do, as this is likely to yield more information.
Buffett and Munger are the best examples. A few years ago, I read a study that looked at Buffett's performance over the past few decades. The study concluded that the billionaire had performed so well because he had concentrated on the market's highest quality companies and used a high level of leverage to increase returns. It also noted that, in theory, any other investor could have copied the same approach. One would have achieved similar returns if one had just bought the S&P 500 on leverage.
Based on this information, one might ask where all the other Buffetts are. If it were that easy, why haven't legions of other investors been able to replicate his returns?
Inverting the results
This is where inversion comes into play. It's straightforward to look at Buffett's portfolio and conclude that he has performed well because he has focused on high-quality stocks. Therefore, any other investor should be able to replicate his approach by borrowing money and investing in high-quality businesses.
However, we need to focus on what he hasn't done, as well as what he has. This is the fun part. When we look at it this way, there are a couple of things that stand out.
Firstly, Buffett has the mentality to buy and sit on his investments for years. In other words, he hasn't sold frequently. Other highly successful business managers and owners have also shown this trait. Second, on multiple occasions, Buffett has been able to get out of sticky situations by using his clout and financial firepower - i.e. he didn't get trapped by situations that would have trapped other investors.
Going back as far as the early 1960s, Buffett was able to unlock value at Sanborn Map using his capital to win a proxy contest. Another notable scenario was Salomon Brothers, Inc. By becoming the chairman of the investment bank, Buffett restored confidence in the business and rescued his investment.
Third, Buffett has been able to structure deals in a way that suits him, which has everything to do with the strenght of his business and nothing to do with his investment principles. In the financial crisis, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) became a lender of last resort. It invested a total of $25 billion in different companies and virtually dictated the deal terms. The company could only do this because of its size and reputation.
By inverting the situation, we can see the real reasons why Buffett has been able to outperform. These reasons suggest that the average investor will not achieve similar results, even by following his investment ideas.
And by having this information at hand, investors can develop a strategy around their own investment principles and ideas rather than blindly following the Oracle of Omaha on the assumption that his investment strategy has always worked best, as there have been other contributing factors. Ignoring these factors could lead to incorrect conclusions.
