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High Probability and Defensive Investing

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by Paul Kindzia in Personal Finance
August 21, 2020

Charlie Munger always quipped, “All I want to know is where I’m going to die, so I’ll never go there…”

Munger is the right-hand man of Warren Buffett.  Whereas Buffett is much more famous and covered by the media for his enormous wealth along with his down-to-earth demeanor, Munger is known for his funny, quirky, life-wisdom pearls that he shares with his loyal followers.  The 95-ish year-old-billionaire is continuously willing to share his thinking process, which uses a lattice of mental models that could be applied not only to investing but also to managing a successful and happy life.

It is Munger, who is worth $1.7 billion, who rattles off investing wisdom nuggets that seek to simplify the investing process while navigating life.  Munger teaches investors to invert situations and look at things from the opposite perspective.  Rather than seeking brilliant and complex moves in complicated markets, Munger seeks to make fewer dumb mistakes than other people and then strives to fix his errors as quickly as possible.

Munger’s approach is much like Einstein’s.  Both have the desire to eliminate the superficial details that do not matter and get down to the essential things that matter the most.

Munger pays just as much attention to defense as he does offense.  When Buffett and Munger speak of their lifelong success in the financial markets, they gravitate back to two rules of investing;

Rule #1 – Do not lose your capital

Rule #2 – Do not break Rule #1

When most people approach the financial markets, they approach it from a perspective of “all offense, all the time.” Ordinary people typically do not use the mindset of probability analysis for decision making, whether for investing or other purposes.  Ordinary investors tend to only think of the upside potential while ignoring what the downside risks are, what could go wrong, or how things can turn against them.

To be successful in investing over the long-run, you have to avoid the significant losses that typically wipe out most investors every decade or so when bubbles burst, cycles end, and all risk management is thrown right out the window.  Further, you want to avoid situations where you could get into personal liquidity squeezes.  Liquidity squeezes occur when you have personal debts that must be paid while personal revenues get interrupted at the most inconvenient times.

You can become a better investor if you can visualize an investment matrix when allocating your hard-earned savings.  Utilizing such a thought process forces oneself to think in terms of probabilities, the possible upsides, but also the potential downsides.  Only then could you make genuinely rational decisions void of emotional excitement rooted in greed or wishful thinking.


If you look at the Investment Matrix above, you will see four boxes representing four different scenarios.  Our goal while investing over our lifetimes is to stay disciplined at all times and limit ourselves to only making “High Probability Investments.”  You want to think of investments in terms of owning businesses that have a future stream of cash flows that you have an ownership in.  It is cash flows that make you wealthy.  Paper wealth could be here one minute and gone the next.  Cash flows pay your bills and can buy you beautiful things, or allow you to participate in enjoyable life experiences.

High probability investments are those that can be purchased at attractive prices relative to the future cash flows from the underlying businesses that you are investing in.  Having cash flows alone is not enough to provide a high probability investment.  The price you pay at the START of the investment makes the overall investment a high probability investment or a low probability investment.  Simply put, if you pay too much for any investment at the start, the probabilities of a future positive outcome diminish.  If you overpay for any investment, your future gains are going to be muted because you overpaid at the time of purchase.


To go through an example of probabilities analysis, let’s use Las Vegas as an example.

If someone asks, “Is Las Vegas always a bad bet (investment)?”  Most rational people would respond, “Yes, Vegas is a bad bet.  You will probably lose your money going to Las Vegas.”  (Then they would go to Las Vegas, drink, and gamble…). Munger would teach you to invert your thought process.  Munger would probably say, “Vegas is an excellent investment, I would love to own a casino and have all of those people make bets at my business knowing that the odds (the probabilities) are against them.

The first lesson then is – there are always two sides to a trade or investment.  For every buyer, there has to be a seller.  You can’t buy a stock (no matter how cheap or expensive) unless someone sells it to you.  When applied to Las Vegas, you technically could be a gambler or a casino owner.  Which would you rather be?

The second lesson is to focus on high probability investments while avoiding low probability investments.  High probability investments mean that the math is on your side.  We know that if you consistently made high probability investments (buying assets at reasonable prices that had good revenues, earnings, and cash flows), you would win (experience gains) far more times than you lost.

So Quadrant’s I and II represent high probability investments where you know that mathematically you are making good bets (from the perspective of the casino).  If you were a casino operator in Las Vegas, you know that allowing your customers (the gamblers) to make bets at your casino would be a high probability bet.  Most of those bets would be winners for you (Quadrant I).  But there would also be some losing bets where the casino had to pay out and thus would experience some losses (Quadrant II).

In both Quadrant I and Quadrant II, the probabilities were favorable for you as the casino.  They were high probability bets even though you had some losing bets along the way (Quadrant II).

Now let’s imagine being a gambler at a Las Vegas casino.  You know right up front, unless you are a professional poker player sitting at a table with amateur tourists, you would be making low probability bets at most of the casino games (slot machines, blackjack tables, roulette tables, etc.). Simply put, the probabilities are such that the more you play, the more the mathematical probabilities will take over, and you would find yourself losing all of your money.  The more you play, the more you lose.  Most of Las Vegas (from a gamblers perspective) is spent in Quadrant IV (low probability losing bets).

However, there has to be some bells, whistles, horns, and lights flashing to keep people gambling.  There have to be some events that fall into Quadrant III (low probability but winning bets) to keep people at the casino dreaming about free and easy money.  That’s a necessary component of Las Vegas.  If they didn’t have action in Quadrant III to keep people excited and addicted, Las Vegas would crumble.

Quadrant III is a trap.  A winning bet was still a bad bet, even if it had a short term positive payoff.  You have to be smart enough to know that this is part of the business model AND you must have the emotional discipline to avoid the craps tables.  Knowing that Las Vegas is stacked against you is only half the battle.  It’s actually more important to have the emotional ability to skip the gambling tables and head over to the extravagant food buffets, and entertainment shows to come away with a good value from Las Vegas before heading back to your day job on Monday.

This mental approach to capital allocation could and should be used on Wall Street as much, if not more, than using it at a Las Vegas casino.  When investing your hard-earned capital, you must avoid Quadrant III and Quadrant IV investing opportunities at all costs (even if there are some bells and whistles going off and shining on some winners).

Just like Las Vegas, Wall Street operates by getting ordinary folks to put their money in Quadrant III and Quadrant IV.  These are low probability bets that, over time, are just going to drain you of your savings.

Having a winner in Quadrant III on Wall Street doesn’t make you a smart or wise investor.  It actually has the opposite effect.  You THINK you are a smart investor because you took a gamble, and it had a short term positive payoff.  But it still was a low probability bet.  But after experiencing some winners, ordinary investors continue to make poor bets until alas, their capital is gone.

When bubbles emerge and stick around on Wall Street for a while (and this happens at the end of every investment cycle), the general population gets trained into thinking that Quadrant III bets are smart bets.  Nothing could be further from the truth.  Quadrant III bets just keep you at the tables until you start experiencing Quadrant IV results (which undoubtedly come).


Chart courtesy of Advisor

Stock valuations relative to our economic GDP have never been as high as they are now in market history.

We are in a massive bubble right now.  Prices have deviated so much from value that people are getting sucked into the casino machine just like 1929, just like Japan in 1989, just like the NASDAQ in 1999/2000, just like the real estate bubble of 2002-2007, and just like all bubbles in past history.

Bubbles don’t always burst when YOU think they should burst.  They burst when the masses wake up one day and realize that the crowd is all going broke around them, and then it turns into cockroaches trying to find the nearest refrigerator to hide under.

Don’t let markets pull you from your own intuition and skepticism.  Ask yourself from a common-sense perspective if it makes any sense that as we were in grossly over-valued markets the last few years that we should be breaking new records in the stock markets when;

  • We are clearly in a deep recession that appears to be worsening, not improving.
  • Thousands of small businesses are closing their doors permanently.
  • Almost 40 million American households are at risk or either eviction of foreclosure in the coming months.
  • Industries that are a large part of our economy, such as the airline, hotel, restaurant, rental car, gym, education industries, are either on the brink of bankruptcy or hanging on by a thread from government support.
  • Debt levels are at record levels for sovereign nations, states, municipalities, corporations, and individual households.
  • Tens of millions of Americans are unemployed and just lost their unemployment benefits.
  • We are in the middle of a global health pandemic.

Would common sense tell you that stocks are a better value now than before the above listed items unfolded over the last few months?  Are we collectively in better financial shape now than before the Coronavirus pandemic began?

Sadly, this isn’t stopping millions of Americans from gambling in the stock markets.  They have and continue to be sucked into Quadrant III and Quadrant IV investment scenarios.

The Role of Your Advisor

As your financial advisor, my role often comes down to two critical areas.  First, is the technical and mathematical side of financial advisement.  The financial world continues to get more complicated, not less complicated.  My objective is to be in a strong position to assist you in sorting out the complexities of strategies, tools, resources, and offerings in terms of investments, financial planning, taxes, insurance, and estate planning, to name a few.  My focus is to allocate capital in high probability investments while avoiding risky low probability investments.

This portion of analytical services must be done through a lens of loss prevention, not only to prevent investment losses, but just as essential to protect you from Wall Street, Big Banks, Insurance Companies, and the Government itself.  These entities have become quite crafty of looting us and taking our money (legally), albeit with weak morals and ethics widely displayed through their past experience and misdeeds.  Our puzzle is one in which we are trying to become wealthy while at the same time not being looted by those who are “offering us their helping hand,” which seem to find ways into our pockets.

The second role of being your advisor is to keep you focused on the behaviors of success.  We often have a hard time getting out of our own way.  Humans come pre-programmed with some behavioral flaws and biases that are well known and documented.  These behavioral flaws are mixed in with human emotions, and when that happens, all logic and common sense gets thrown right out the window.

With the threat of significant losses present in the equity markets, the better mathematical bet is in areas not related to extremely valued stock prices.  Further, we know that the government is doing massive stimulus injections along with large amounts of quantitative easing.  It is a goal for central bankers to keep interest rates down (due to the enormous leverage and debt in the system, including government debts).

We expect central bankers to print, stimulate, support, and bail-out players that are politically attractive to their own self-interests.  We also expect the central bankers to support their own bond markets (in our case, we expect our Federal Reserve to defend, support, and control the U.S. Treasury bond market and interest rates).  They will buy their own bonds issued by the Treasury Department if needed to fund our bailouts and continued government deficits no different than they have in the past.

What this means is that from an offensive and defensive investing perspective, we will assess the likely possibilities while using the most favorable probabilities.  Thus, we should be tilting towards a strong defensive posture with our equity exposure, while stock valuations are at extreme levels.  Our offensive opportunities will be targeted towards areas that tend to do historically well during a crisis with government support, stimulus, and bailouts.  These offensive areas would include sectors like U.S Treasury bonds, gold, other precious metals, metal miners, and investments with reliable and consistent cash flows and distributions.

While we don’t know if we will be entering a period of inflation or deflation, patience will be a valuable practice.  Our objective will remain the same.  We intend to continue to build and protect wealth that results in not only protecting our hard-earned savings but also allowing us the opportunity to move much more offensively into opportunities that reveal themselves on the backside of a financial crisis.  We are in the early innings of a financial crisis.

If you have any questions, please feel free to reach out and contact me.  I am here for you.

Below, with my Expanded Third Edition of “Poor Charlie’s Almanack” written back in 2005 which covers the wit and wisdom of Charlie Munger.  It is one of my top five books of all time for investing and for life.

Good habits lead to good behaviors.  Good behaviors lead to good decisions.  Good decisions lead to a good life.  Live by principles and choose wisely.

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