One of the worst bad habits I’ve seen many investors exhibit is a tendency to focus on all the reasons why what they’re doing should work out perfectly, rather than spending any time exploring why it might not.
In behavioural finance circles, this is called confirmation bias and can lead to some pretty painful mistakes.
Charlie Munger – Warren Buffet’s long-time business partner, and one of the greatest investors of all time – came up with a way to counteract this tendency by subscribing to what he calls “inversion thinking.”
Before making any significant new investments, the first thing Munger does is sit down and try to list all the ways it could go really badly. He seeks out all the contrarian evidence and opinions he can find.
Only after he has sifted through every conceivable reason for why it might be a terrible investment does he allow himself the luxury of thinking about why it might work out all right after all.
This strategy has led Munger to reject so many investments that Buffett jokingly refers to him as “the abominable no-man.” But it’s also a very large part of the reason for his extraordinary success. While we may not all be billionaires, we can still see the value of Munger’s inversion approach in other ways in our financial lives.
A few years ago, for example, retirement expert Frederick Vettese wrote a book called The Essential Retirement Guide: A Contrarian’s Perspective. In it, he says that if you were to ask anyone who has a pension whether they would trade that pension for a lump sum of cash, the vast majority of people would immediately say no. At the same time, if you asked someone without a pension if they’d like to exchange their life savings for an annuity, most would also instantly answer with a resounding “no.”
The point of this story isn’t to say that one of these retirement strategies is better than the other. It’s to highlight the fact that, all too often, investors rely on little more than their gut instinct to make snap decisions about even their most important financial choices without first taking the time to really consider the question or think through all the possibilities.
Take Bitcoin as an example. All we have to do is look at the recent rollercoaster ride surrounding virtual currencies to see how certain assets can provoke some pretty heated debates. Unfortunately, those debates don’t tend to take the form of a rational discussion about the pros and cons of the actual investment. Instead, they usually boil down to a passionate defence of the asset by investors who already own it, and a vehement insistence that it’s clearly all just another fad by those who don’t.
The trouble with entrenched positions like these is that they can lead to portfolios that are essentially just glorified all-or-nothing bets. Investors become so convinced by what they see as the truth of a particular narrative that they drop more and more of their money into one sector, or even a single company, without weighing the potential risks.
This isn’t a new story, either. From energy stocks in the 1980s and the 2000 dot-com bubble, to more recent “can’t miss” investments such as Bitcoin, cannabis stocks or emerging markets, the frenzy to not miss out can make even the most legitimate assets so expensive that all common sense just up and leaves the room. Which is all fine and good, until the bottom of these over-inflated assets inevitably falls out, and all those investors who didn’t get out in time are left holding the (often empty) financial bag.
One of the most hotly-contested narratives that’s permeating the investment landscape today is the fear of inflation. It’s no small wonder. Spurred by the pandemic, governments around the world are competing to see who can spend the most money. But while runaway government spending often leads to inflation, it isn’t always the case. After all, if government spending always resulted in accelerated inflation, then Japan should be the inflation capital of the developed world. Yet in spite of massive government stimulus, Japan remains one of the most stubbornly inflation-resistant nations on Earth.
All of which brings me back to Charlie Munger, and the threat of confirmation bias. If you, like many investors, suddenly find yourself tempted to cash out your entire portfolio and invest everything you own in gold or some other traditional hedge against inflation, it may be worth taking a few moments first to stop and ask yourself the question: What if inflation rates don’t skyrocket overnight? How would having half of your net worth invested in a single asset impact your long-term financial plan? And are you putting too many eggs in that one particular basket?
As Buffett likes to say, nothing scares him more than a cheery consensus. When everyone around you seems convinced that the future can only go one way, that’s usually my signal to stop, take a deep breath and think about all the ways they just might be wrong.
This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.