The Power of Inversion in Investing

A Look at the Markets: No Santa Rally this Year

It’s evident from the chart below that the S&P500 didn’t experience a Santa Rally this year. Nevertheless, investors should recall that the markets had already received a positive impact from Trump’s election in early November. Furthermore, as mentioned last week, the S&P500 achieved a remarkable return of approximately 24% in 2024, so investors should be pleased rather than disappointed.

The S&P 500 was up 4.3% between the 1st of November 2024 and January 6th despite there being no Santa Rally (period shown in the shaded yellow box).

The Power of Inversion in Investing

In our sister newsletter, Business Fluency, we talked about inversion theory. This concept is so fundamental to successful investing that I want to explore it further here, focusing specifically on how it can protect and grow your wealth.

The Art of Thinking Backwards

Consider this: before making any investment decision, what if you first thought about what could go wrong? This approach, known as inversion thinking, was championed by Charlie Munger, one of history's most successful investors. Munger's famous quote captures this perfectly:

In investing, understanding what to avoid can be more valuable than knowing what to pursue.

The Investment Legend

Charlie Munger, serving as Vice Chairman of Berkshire Hathaway alongside Warren Buffett, transformed investment thinking. Rather than solely focusing on potential returns, Munger built his remarkable track record by first identifying and avoiding significant risks. This approach helped Berkshire Hathaway become one of the world's most successful investment companies.

Early Lessons in Risk Management

Munger's risk-awareness mindset developed during World War II, when he served as a meteorologist. Instead of simply seeking perfect flying conditions, he asked himself,

By identifying critical risks - severe icing and excessive distance from landing sites - he developed strategies that saved lives. This same principle can protect your investment portfolio.

Protecting Your Wealth Through Inversion

When applying inversion to investing, start with this crucial question: What's the absolute worst outcome to avoid? The answer is straightforward - losing all your money. This clear understanding leads us to perhaps the most important principle in investing: diversification.

Smart Diversification in Practice

My personal investment strategy reflects this protective approach. The cornerstone of my portfolio is a Global ETF, which provides exposure to numerous companies worldwide. While this investment may fluctuate in value, the probability of it becoming worthless is extremely low - you'd need every major company in the world to fail simultaneously.

For individual stock investments, I never allocate more than 2% of my portfolio to any single company. This means that even if one investment goes to zero (which can happen even to seemingly stable companies), my overall financial health remains secure (and I can sleep easily at night!).

Remember: successful investing isn't just about finding opportunities - it's about systematically avoiding crippling losses. Sometimes, the best investment strategy is simply avoiding the worst mistakes.

How can you apply this thinking to your own investments?

Start by asking yourself:

Consider that not investing at all, for example by keeping your money in a bank, is also a risk. We will revisit debasement of currency next week.

The Danger of Market Predictions

Last week, we discussed why I avoid making market predictions in these newsletters. Today, let's look at why you should be cautious about basing your investment decisions on anyone's predictions - even those from major investment banks.

Let's consider a real example from last year. At the start of 2024, some of the world's largest investment banks made predictions for where the S&P 500 would end the year. Their forecasts ranged from 4,200 (JPMorgan) to 5,100 (Deutsche Bank). However, the S&P 500 actually closed the year around 5,900 - significantly higher than even the most optimistic prediction!

Even these sophisticated institutions, with their teams of analysts and access to vast amounts of data, couldn't accurately predict the market's movement. JPMorgan's prediction was off by about 1,700 points, while even Deutsche Bank's most optimistic forecast fell short by 800 points.

So what's the answer? My answer is to ignore the predictions and invest regularly (dollar-cost averaging) into a global ETF.

Remember: The market's unpredictability is precisely why we need solid investment principles rather than relying on forecasts - even from respected sources.

S&P 500 performance 2024

I began this chart on November 20, 2023, when the Goldman Sachs prediction for 2024 was released. As you can observe, the S&P 500 surpassed its target price for the end of 2024 before the year even commenced (I acknowledge that the market could have had a major pullback to this level).

On a different note, I believe the chart presents an ideal year for investors - it exhibits a consistent upward trend accompanied by healthy pullbacks (indicated by the blue trendlines).

However, it is essential to remember that past performance does not guarantee future results. The chart for 2025 may present entirely different dynamics.

Word of the Day: Crippling

Note: This is a word you should understand but not necessarily use. I used it in the inversion section of this newsletter to provide context. You’ll hear it, so it’s important to understand it. However, be cautious not to offend anyone if you use it because it can inadvertently evoke associations with physical disabilities. An alternative word is catastrophic.

Definition: Crippling - adjective

1. So severe as to seriously damage or harm someone or something's ability to function

2. Causing severe difficulties or hardships that prevent normal operation or progress

In financial context: Referring to losses or debts that severely impact one's financial well-being, making it difficult or impossible to recover or maintain normal financial operations.

Example in use:

Related terms:

• Cripple (verb)

• Crippled (adjective)

Remember: In business English, "crippling" is often used to describe severe financial hardships or operational difficulties that significantly impair but don't completely destroy an organization or portfolio.

Word of the Day: Catastrophic

Definition: Catastrophic - adjective

1. Involving or causing sudden and widespread disaster or misfortune

2. Extremely harmful; bringing about ruin or devastation

In financial context: Describing an event or loss that results in complete or near-complete destruction of value or operational capability, often beyond recovery.

Example in use:

Related terms:

• Catastrophe (noun)

• Catastrophically (adverb)

Remember: In business English, "catastrophic" implies a more severe and final outcome than "crippling" - while a crippling loss might severely impair operations, a catastrophic loss suggests complete destruction or ruin.

💡 Quick tip: When discussing risk management in finance, "catastrophic risk" often refers to events that could lead to total loss or bankruptcy.