How Inversion Can Be Used to Make Better Investment Decisions

Mental models are thinking tools we use to process our thought patterns and make decisions and solve problems.

They are a reflection of one’s understanding of life. When faced with difficult investment choices, mental models can be used to break down the seemingly complex process of making appropriate decisions. 

In investing, mental models can be used to guide our investment decisions, helping us to reach our desired goals. It can act as a guideline for making financial decisions from choosing stocks to setting up a business or retirement plan.

One of the mental models which can be used to guide financial decisions is Inversion. This is a simple model which can add another dimension to the decision-making process. 

So, what is it and how can we use it to make the best investment decisions? Let’s dive right in!

What is Inversion?

Inversion is a mental model that involves looking at a problem in reverse to fully assess or understand the situation.

Inversion involves taking an opposite approach to the conventional way of thinking. The main objective is to weigh two sides of the problem to give you an unbiased assessment of the situation. 

Its basic premise is anchored on understanding the problem rather than chasing the solution.

Instead of trying to reach a solution, ask how you can avoid the problem. It is especially useful when one can’t decide on a particular issue, or is unclear about the outcome of an intended action. 

Where Did Inversion Become Popular?

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.   

To have an understanding of a complex problem, you should turn the problem on its head.

Assessing a difficult situation backwards led to a better understanding and opened up new angles at which the problem can be approached. 

In investing, Charlie Munger is perhaps inversion's most famous proponent.

He suggested that it should be used in everyday life decisions and not just when faced with financial trivia. Munger suggests that many problems can’t be solved with forward or unidimensional thinking. You need to think about them both ways (forward and backward) to get to their core. 

Munger believes that investors would be better off if they avoided stupidity rather than trying to reach for brilliance.

His famous quote...

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

...extols the benefits of making safe decisions rather than trying to hit it big with grandiose attempts.

As such, while inverting a problem may not necessarily solve it, it can help one avoid taking a disastrous action. 

Inversion is a mental model that allows us to think about an objective in reverse, which is often the way to get to the heart of the problem we are trying to solve with our intention. Usually, you gain a different and more relevant understanding of what you are trying to do.

How Inversion Can Be Used to Make Investment Decisions

Inversion has to do with avoidance.

You look out for factors that could be problematic and lead to failure in your investment and then avoid it. When faced with an investment decision, rather than think about how you can grow your capital, think of the ways you may lose it. 

For example, if you want to open a business, while it is easy to be lured by the opportunities, you should also take note of the roadblocks and challenges.

You can consider this by asking: what are the ways that a business could fail? When you have taken this viewpoint, it is clearer to see ways in which you could avoid taking a bad investment decision. 

The stock market has been on its longest bullish run, with stocks reaching record highs.

Due to the rising inflation rate, there is a lot of chatter about an impending pullback in the stock market when the Federal Reserve decides to raise the interest rate to control inflation.

Conventional thinking would first consider the fact that the prices of stocks would fall, and so it is better to pull your money out of the market. Inverse thinking on the other hand asks, what if the drop is an opportunity to buy cheap stocks of quality companies? 

Ideas on Using Inversion When Making Investment Choices

The table below shares some ideas on how you can use inverted thinking when faced with certain financial decisions:

3 Benefits of Using Inversion in Financial Decisions

1. Helps identify areas of risk

By looking out for ways an investment could go bad; you are inadvertently considering the risks involved. Identifying risk areas does two things for an investor. First, it prepares you for the worst outcome and it also helps to avert potential losses by avoiding investments with higher risk.

2. Sets the basis for targeted diversification and hedging

When you have appropriately identified potential flashpoints in your portfolio structure, you now have a better picture of how to diversify your investments or hedge against the risks.

One way to effectively diversify is investing in assets that are inversely correlated to the risky assets in your portfolio.

3. Prioritizes capital preservation

Using an inverted approach to making financial decisions reinforces the number one rule of investing - never lose your capital.

Inversion shows you the ways you could lose money in an investment.

When you weigh your options, you would take the safest alternative. Even if you want to take on some amount of risk for example investing in a growth stock, you would take the alternative that has the least amount of risk rather than the highest amount of gain.

Such an approach seeks to preserve the capital because you have identified the ways you could lose it. You can either avoid those areas or hedge against them. 

Key Takeaway

When faced with investment decisions, it is easy to get blindsided by anticipated gains without considering potential areas that could cause bring loss.

Such assessment can lead to poor investment decisions. The law of inversion enables investors to have a total picture of the situation. It also acts as a check on emotions and ensures that we do not get carried away.

Avoiding bad investment choices is an easier path to long-term financial success than adopting an aggressive risky approach by investing high-yield assets or trading with high margins.

Photo by Corinne Kutz on Unsplash