Recently I picked up the book The Great Mental models written by Shane Parrish. For those who may be unfamiliar with the idea of mental models, mental models are like frameworks for thinking. They help to simplify complex ideas allowing your brain to reason through them. The goal of acquiring mental models is to be able to apply these chunks of knowledge and identify when certain models are at play. If you’re able to do this well, you’ll be able to use these models to make better decisions in life.
According to Parrish, making better decisions has less to do with pursuing the best outcomes and more to do with avoiding the worst. Parrish states that “Sometimes making good decisions, boils down to avoiding bad ones.” A lesson worth exploring if you’d like to be a successful investor over the long-term.
Charlie Munger – Warren Buffett’s business partner and easily one of the most successful investors of all time has been quoted as saying “All I want to know is where I’m going to die, so I’ll never go there.”
In investing, identifying when an investment has the potential for large losses, and avoiding the investment is the equivalent of knowing where you’ll die and not going there. It’s the essence of Munger’s quote and at the core of what makes mental models so powerful as they relate to investing. The majority of professionals and everyday investors obsess over trying find the next investment that will 10x their money. In doing so, these investors ignore very real and highly probable risks that can come with considerable consequences if they emerge. A simple review of how the math works can help us to understand why avoiding big mistakes is more important than finding big winners. Or as Parrish puts it, making a good decision by avoiding a bad one.
Let’s assume you had $100,000 invested. If that $100,000 suddenly dropped -50% because you or your advisor was caught up in the latest investment trend, you now need to earn a return of +100% just to get back to even. It gets exponentially worse if your investment dropped -60%, with a return of +150% needed to recoup the loss. -70% and +233.3% is required.
Investors and advisors who emphasis protection first don’t have the same hole to dig themselves out of which ends up being a huge advantage. If we look at what’s needed to recoup a loss of even -40%, the required return is only +66.7% (a whole 33.3% better than our first scenario). If you were even better protected and only experienced a -20% loss, the return you need to get back to even drops to +25%.
In September of 2019, I wrote a cheeky piece about recession proofing your investment portfolio. In it I examined Warren Buffett’s Berkshire Hathaway conglomerate and how their long-term track record (50+ years) of significant outperformance of the market, had more to do with Buffett’s behaviour and protection during down markets, than it did anything else. When the dotcom bubble burst, Berkshire Hathaway fell -28%. The S&P500 over that same period was down -45%, which left Mr. Buffet and Mr. Munger a much smaller hill to climb in order for their portfolio to be back to being positive.
Whether it’s the dotcom bubble of 90s, marijuana stocks, or high-flying Tesla. The majority of investors behave in a way, where they focus too much of their thought on the potential gains an investment might yield, at the expense of thinking about the possible consequences should they be wrong or should something unexpected occur. It happens time after time, wealth is destroyed via careless risk taking and lack of truly considering the magnitude and probability of worst-case scenarios.
Who would you rather be? The investor whose been able to 10x their money on one or two investments, but over the last 25 years has a number of mistakes that’s caused their true long-term average return to be somewhere near 3% per year? Or the investor who over those same 25 years made smart asymmetrical bets and has compounded their wealth at an average annual rate of 8% because they’ve been able to avoid major losses? One is A LOT wealthier than the other.
Crashes, corrections, and unexpected events will occur. It’s par for the course when it comes to investing and in life. The ability to think about the possible negative outcomes and the probability they might occur will help you to better protect your portfolio and ultimately lead to better long-term investment results.
- Brandt Butt, Investment Advisor, CIM®
Brandt Butt is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Brandt Butt who is an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.