Charlie Munger said: All I want to know is where I’m going to die, so I’ll never go there.

A lot of success in life and success in business, says Munger, “comes from knowing what you really want to avoid-like early death and a bad marriage.”

Buffett’s 2 Rules of Investing

Rule 1: Don’t lose money.
Rule 2: Don’t forget rule 1.

John Paul Getty, an American business tycoon, said –In every business deal or transaction, identify the worst thing that can possibly go wrong, and then make sure it doesn’t happen.

This approach by the famous investors is based on a mental model that involves looking at a problem in reverse to fully assess or understand the situation, this mental model is called Inversion.

Inversion was first popularized by German mathematician, Carl Jacobi back in the 1800s.

Jacobi is credited with the famous quote, “invert, always invert." Jacobi used inversion in solving math problems by reversing them. By rewriting the problem in its opposite form, it became easier to solve.   

How can you apply Inversion for investing in stocks?

Inversion has to do with avoidance. It’s not focusing on how to make money, instead it asks you to invert the problem and ensure that you don’t lose money, avoid investing in bad businesses and focus more on things to avoid for investing failure.

Some of the things that you must not / and must do:

1.    Do not invest through intermediaries or advisors as their interests may not be aligned with yours. The incentives for the intermediaries are earned when you buy the stocks and the issuers pay the incentive.                 

2.    Don’t ignore learning vicariously: learn from the mistakes of others by reading the best books on the subject. Human nature has not really changed all these centuries. The same emotions of greed and fear keep on returning repeatedly. 

3.    The other thing that you can do vicariously is to observe the mistakes of other investors and businesses. So instead of only focusing on things that go right, you must also focus on things that go wrong – and learn to avoid doing things that produced those mistakes. 

4.    Don’t Ignore odds in terms of prior probabilities in specific sectors/industries. Understand what has really worked well and what has turned out to be a disaster – and to learn from both 

5.    Find role models: you must read through the lives of these people (for e.g. Warren Buffett, Charlie Munger, Ben Graham etc), and what have they done over the years and how did they learn, and then learn from their experiences vicariously 

6.    Value of patience: focus on the long term 

Suggested Investment Framework:

Focus on investing in businesses with good management, with durable moat which provides long term competitive advantages, that are available at reasonable valuation, these companies lower the risk of permanent loss of capital.

1.    Circle of competence: Do you understand the business? Is the business and products/services simple? Learn the business by reading through the annual reports. Do not confuse familiarity with competence. What could go wrong? 

2.    Financial consistency and past results: study the past 7 to 8 years financials focusing on balance sheet strength and cash flow (key ratios). Is the business profitable? Financials consistent? Positive cash flow? 

3.    Does the business have a durable moat: compare the financials (KPIs) to main competitors, are the results consistently better? Is the management competent and ethical, no legal cases on those lines or in media? Future growth opportunities? Efficient capital allocation? Patents, brand and pricing power. 

4.    Stock price or valuation: is the valuation reasonable or excessive? Margin of safety? What could potentially go wrong? Use different valuation methods to triangulate the price to the value (current price and expectations built in, comparable multiples etc) 

5.    Stocks that pass the pricing filter can be potentially added to your portfolio, if the price is high then put these in watchlist with a target price, assuming they passed all other filters 

6.    Most importantly after following the process, don’t keep questioning the decision, don’t track portfolio on daily basis and stay away from the expert advice!