Public Domain. Source: US Army
Inversion is a solid analytical technique. Some problems are best solved by thinking backwards. The Stoics used this approach 2000 years ago. They called it “premeditatio malorum” – imagining what could go wrong. That way, they considered, you won’t be shocked and appalled when life sends you unpleasant surprises.
We’re taught to do this behind the wheel. My instructor called it defensive driving, imagining what unpredictable moves other drivers might make. The NPR call-in show “Car Talk” had some fun with this idea a few years ago. They played a song about a fictional conversation between a grandfather and his granddaughter, where he distilled his years of wisdom about safety on the road:
“They’re all jerks, not a one knows how to drive,
So you’ve got to pay attention to keep yourself alive.
I’ll tell you my philosophy, I guarantee it works,
Repeat it after me kid: ‘They’re all jerks.’”
Inversion works in business planning: “Our new product just failed,” the CEO tells his executives a week before the roll-out. “What went wrong?” Such planning, called a pre-mortem, is a staple of project management today. Far too many ambitious undertakings fail for mundane, preventable reasons. Naïve optimism and rah-rah thinking can blind us to taking sensible precautions against adverse developments. What if similar product comes out at the same time? What if a key supplier goes bust, or a critical employee falls ill, or is poached by a competitor? Contingency plans are always part of any successful operation. It’s the reason we wear life vests when we’re boating.
And inversion works with investments. It’s why we diversify. What if oil prices double, or fall by half? What if the Euro-zone breaks up. How about a cyber-attack on our internet infrastructure? Or a nuclear accident on the Korean peninsula? Imagining adverse scenarios allows us to structure resilient portfolios that hold up when things go wrong. Indeed, diversified, low-risk portfolios tend to underperform in long, trending markets. That’s one of the reasons many people are excited about indexing right now – the winners keep on winning, and it’s hard for a disciplined, diversified portfolio manager to keep up.
But diversification is at the heart of sound portfolio management. Complacency kills. No one plans to fail. Many folks fail, though, because they don’t plan. Inversion and contingencies should be part of any investment process.
Douglas R. Tengdin, CFA