We spend lots of time thinking about the future. This is especially true for those of us who put capital to use seeking to obtain a return, relative to a certain amount of risk assumed. Prospectively, we consider our options and imagine various outcomes. Afterward, we evaluate the results to figure out what went right or wrong.
There’s the problem. Once we know a specific outcome, our analysis of the entire process becomes tainted. World-champion poker player Annie Duke uses the term “resulting.” It is an after-the-fact explanation for a recent event, ignoring random outcomes, discounting luck and using one’s hindsight bias. As you might imagine, people who engage in “resulting” fail to improve their processes.
One solution to these sorts of problems is to consider alternative outcomes. I am not referring to the wishful thinking of “If only we bought Amazon at $9 and Bitcoin at 50 cents.” Rather, it is imagining scenarios where small changes might produce very different outcomes. I refer to the counterfactual, a very useful tool for investors, gamblers — indeed, to anyone trying to analyze events with uncertain outcomes.
The term itself was coined by Nelson Goodman in his article “The Problem of Counterfactual Conditionals.” But the idea has been around for a long time. Air Force Colonel John Boyd, who helped change the art of air warfare, said “If you want to understand something, take it to the extremes or examine its opposites.” Berkshire Hathaway’s Charles Munger famously said “Think forwards and backwards — invert, always invert.” (Though Munger lifted that phrase from Carl Gustav Jacob Jacobi, the great 19th-century Prussian mathematician, he is often credited with the maxim.)
How can we use the counterfactual to help us solve investment or other thorny problems? Let’s consider a few examples of counterfactuals to see what light they might shed. I used the technique around the idea of U.S. government bailouts:
— What if General Motors and Chrysler hadn’t been bailed out?
— What if JPMorgan Chase hadn’t received guarantees for $29 billion of Bear Stearns Cos.’s liabilities?
— What if Citigroup Inc. and Bank of America Corp. had been put into bankruptcy?
— What if American International Group Inc.’s counterparties hadn’t been made whole by the federal government?
There is a persuasive case to be made that under alternative scenarios there might have been more pain short term, but healthier economic and political outcomes over the long term.