Investors
are
an
optimistic
bunch.
Naturally,
we
think
of
a
brighter
future,
where
assets
appreciate
and
compound
our
wealth.
To
think
otherwise
would
give
us
little
reason
to
invest.
Yet
here’s
a
counterintuitive
point:
one
of
the
best
ways
to
build
and
maintain
an
investment
portfolio
is
by
thinking
about
the
worst-case
scenario.
Before
you
suggest
that
I’ve
lost
the
plot,
know
that
none
other
than
Charlie
Munger,
Warren
Buffett’s
offsider,
has
my
back
on
this
point.
Well,
sort
of.
Munger
has
famously
guided
his
followers
to
“invert,
always
invert”.
By
this
he
means
that
many
problems
can’t
be
solved
by
just
thinking
‘forwards’’
or
toward
the
next
logical
step.
Often,
you
must
think
both
backwards
and
forwards.
Inversion
forces
you
to
uncover
hidden
beliefs
about
the
problem
that
you
are
trying
to
solve.
Applying
Munger’s
thinking
to
my
original
point,
it’s
crucial
to
not
only
think
about
the
best-case
scenario
for
your
investments.
Considering
the
worst-case
scenario
compels
you
to
carefully
think
about
your
portfolio,
including:
1. Asset
Allocation
Let’s
say
that
you
have
a
simple
portfolio
that’s
80%
equities
and
20%
bonds.
And
consider
a
worst-case
scenario
where
the
stock
market
falls
50%
from
current
levels
and
your
equities
do
likewise.
That
means
your
investment
portfolio
would
suffer
an
overall
loss
of
40%
(a
50%
drop
in
equities
multiplied
by
0.8,
the
proportion
of
your
portfolio
in
stocks).
Before
you
say
that
type
of
fall
in
stocks
can’t
happen,
know
that
developed
markets
have
regularly
dropped
by
that
amount,
and
more,
throughout
their
history.
How
would
you
react
to
a
portfolio
drop
like
this?
A
lot
of
investors
would
sell
equities
after
large
losses
and
put
that
money
into
defensive
assets
such
as
cash
and
bonds.
That’s
often
the
worst
thing
to
do,
as
assets
such
as
equities
aren’t
usually
down
for
long.
If
you
can’t
stomach
a
fall
such
as
this,
then
it’s
time
to
reconsider
your
asset
allocation.
Perhaps
you
can
reduce
the
80%
invested
in
equities
and
put
more
into
bonds
and
cash.
Or
you
can
consider
allocating
a
portion
to
assets
that
aren’t
as
correlated
to
equites,
such
as
alternative
assets.
Preparing
for
a
worst-case
scenario
is
a
good
way
to
stress-test
the
asset
allocation
in
your
investment
portfolio.
2. Investment
Style
or
Strategy
One
of
the
biggest
mistakes
I
often
see
is
investors
don’t
have
portfolios
that
reflect
their
personalities
and
temperaments.
For
instance,
you
can
have
an
investor
with
a
conservative
personality
who
has
a
portfolio
100%
exposed
to
growth
stocks.
Thinking
through
the
worst-case
scenario
for
your
investments
can
help
better
match
a
portfolio
with
your
personality.
Going
back
to
our
previous
example,
a
conservative
investor
would
normally
struggle
to
handle
a
40%
fall
in
their
portfolio,
therefore
it
would
make
sense
to
dial
back
the
equity
exposure.
Or
if
you’re
a
retiree
who
relies
on
the
income
from
your
portfolio,
having
a
more
yield-oriented
asset
mix
would
likely
be
a
more
palatable
option.
3. Choosing
Stocks
Let’s
move
from
asset
allocation
to
choosing
stocks,
where
looking
at
different
scenarios
is
just
as
important.
On
this
point,
it’s
no
accident
that
some
of
the
world’s
best
investors
started
out
as
gamblers.
For
instance,
Ed
Thorp
was
an
academic
turned
amateur
gambler,
who
invented
card
counting
and
wrote
a
famous
book
about
it
(Beat
the
Dealer)
when
he
was
30.
Later,
he
applied
his
mathematical
prowess
to
investing,
running
a
successful
hedge
fund
for
19
years.
Jeff
Hass
was
a
professional
gambler
before
cofounding
the
Susquehanna
International
Group,
which
has
turned
into
one
of
Wall
Street’s
most
successful
trading
firms
and
made
him
the
48th
richest
person
in
the
world.
Why
do
gamblers
make
good
investors?
It’s
not
only
about
the
ability
to
take
risk.
It’s
also
about
taking
sensible
risk,
preferably
where
the
odds
are
overwhelming
in
your
favour.
To
do
this
requires
scenario-based
thinking,
looking
at
both
the
best-case
and
worst-case
scenarios,
and
everything
in
between.
You
can
do
this
by
looking
at
earnings
multiples.
You
can
stress-test
the
earnings
and
multiple
attached
in
all
sorts
of
ways.
In
a
worst-case
scenario,
you
can
look
at
an
economic
recession
and
how
that
could
impact
earnings.
Maybe
you
forecast
declining
margins
in
this
scenario
and
lighter
revenue
growth,
resulting
in
earnings
growth
in
the
low-single
digits.
Considering
various
scenarios,
including
the
worst
case,
can
help
you
have
a
better
understanding
of
the
key
drivers
for
companies
such
as
Woolworths
and
their
prospects.
James
Gruber
is
an
assistant
editor
for
Firstlinks
and
Morningstar.com.au.
His
article
originally
appeared
on
Morningstar
Australia
and
has
been
edited
for
a
UK
audience
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