The Most Important Thing: Uncommon Sense for the Thoughtful Investor (Columbia Business School Publishing)

by Howard Marks

Those who try to simplify investing do their audience a great disservice. I’m going to stick to general thoughts on return, risk and process; any time I discuss specific asset classes and tactics, I do so only to illustrate my points.

But unfortunately the limitations of language force me to take one topic at a time.

Thus I begin with a discussion of the market environment in which investing takes place, to establish the playing field.

Then I go on to discuss investors themselves, the elements that affect their investment success or lack of it, and the things the...

The final chapters are an attempt to pull together both groups of id...

In particular, you’ll find I spend more time discussing risk and how to limit it than how to achieve investment returns. To me, risk is the most interesting, challenging and essential aspect of investing.

When potential clients want to understand what makes Oaktree tick, their number one question is usually some variation on “What have been the keys to your success?” My answer is simple: an effective investment philosophy, developed and honed over more than four decades and implemented conscientiously by highly skilled individuals who share culture and values.

One cannot develop an effective philosophy without having been exposed to life’s lessons. In my life I’ve been quite fortunate in terms of both rich experiences and powerful lessons.

The time I spent at two great business schools provided a very effective and provocative combination: nuts-and-bolts and qualitative instruction in the pre-theory days of my undergraduate education at Wharton, and a theoretical, quantitative education at the Graduate School of Business of the University of Chicago. It’s not the specific facts or processes I learned that mattered most, but being exposed to the two main schools of investment thought and having to ponder how to reconcile and synthesize them into my own approach.

If you read widely, you can learn from people whose ideas merit publishing. Some of the most important for me were Charley Ellis’s great article “The Loser’s Game” (The Financial Analysts Journal, July-August 1975), A Short History of Financial Euphoria, by John Kenneth Galbraith (New York: Viking, 1990) and Nassim Nicholas Taleb’s Fooled by Randomness (New York: Texere, 2001). Each did a great deal to shape my thinking.

Finally, I’ve been extremely fortunate to learn directly from some outstanding thinkers: John Kenneth Galbraith on human foibles; Warren Buffett on patience and contrarianism; Charlie Munger on the importance of reasonable expectations; Bruce Newberg on “probability and outcome”; Michael Milken on conscious risk bearing; and Ric Kayne on setting “traps” (underrated investment opportunities where you can make a lot but can’t lose a lot). I’ve also benefited from my association with Peter Bernstein, Seth Klarman, Jack Bogle, Jacob Rothschild, Jeremy Grantham, Joel Greenblatt, Tony Pace, Orin Kramer, Jim Grant and Doug Kass.

I’m convinced that no idea can be any better than the action taken on it, and that’s especially true in the world of investing.

Few people have what it takes to be great investors. Some can be taught, but not everyone . . . and those who can be taught can’t be taught everything.

The reasons are simple. No rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly. Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable.

An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness.

In my view, that’s the definition of successful investing: doing better than the market and other investors. To accomplish that, you need either good luck or superior insight.

Would-be investors can take courses in finance and accounting, read widely and, if they are fortunate, receive mentoring from someone with a deep understanding of the investment process. But only a few of them will achieve the superior insight, intuition, sense of value and awareness of psychology that are required for consistently above-average results. Doing so requires second-level thinking.

You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different.

Second-level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account: • What is the range of likely future outcomes? • Which outcome do I think will occur? • What’s the probability I’m right? • What does the consensus think? • How does my expectation differ from the consensus? • How does the current price for the asset comport with the consensus view of the future, and with mine? • Is the consensus psychology that’s incorporated in the price too bullish or bearish? • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.

Others who simplify are what I think of as “proselytizers.” Some are academics who teach investing. Others are well-intentioned practitioners who overestimate the extent to which they’re in control; I think most of them fail to tote up their records, or they overlook their bad years or attribute losses to bad luck.

All investors can’t beat the market since, collectively, they are the market.

Before trying to compete in the zero-sum world of investing, you must ask yourself whether you have good reason to expect to be in the top half.

The problem is that extraordinary performance comes only from correct nonconsensus forecasts, but nonconsensus forecasts are hard to make, hard to make correctly and hard to act on.

The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.

The theory included concepts that went on to become important elements in investment dialogue: risk aversion, volatility as the definition of risk, risk-adjusted returns, systematic and nonsystematic risk, alpha, beta, the random walk hypothesis and the efficient market hypothesis. (All of these are addressed in the pages that follow.) In the years since it was first proposed, that last concept has proved to be particularly influential in the field of investing, so significant that it deserves its own chapter.

That’s a more or less official summary of the highlights. Now my take. When I speak of this theory, I also use the word efficient, but I mean it in the sense of “speedy, quick to incorporate information,” not “right.”

If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or nonconsensus, view.

One of the greatest ramifications of the Chicago theory has been the development of passive investment vehicles known as index funds.

Everything moves in cycles, as I’ll discuss later, and that includes “accepted wisdom.”

In fact, if you show an adherent of the efficient market hypothesis an investment record that appears to be superior, as I have, the answer is likely to be, “The higher return is explained by hidden risk.” (The fallback position is to say, “You don’t have enough years of data.”)

Once in a while we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise. Those halcyon periods lull people into believing that to get higher returns, all they have to do is make riskier investments. But they ignore something that is easily forgotten in good times: this can’t be true, because if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.

In the vocabulary of the theory, second-level thinkers depend on inefficiency. The term inefficiency came into widespread use over the last forty years as the counterpoint to the belief that investors can’t beat the market. To me, describing a market as inefficient is a high-flown way of saying the market is prone to mistakes that can be taken advantage of.

But it’s impossible to argue that market prices are always right. In fact, if you look at the four assumptions just listed, one stands out as particularly tenuous: objectivity. Human beings are not clinical computing machines. Rather, most people are driven by greed, fear, envy and other emotions that render objectivity impossible and open the door for significant mistakes.

A market characterized by mistakes and mispricings can be beaten by people with rare insight. Thus, the existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it. It does not, however, guarantee it.

To me, an inefficient market is one that is marked by at least one (and probably, as a result, by all) of the following characteristics: • Market prices are often wrong. Because access to information and the analysis thereof are highly imperfect, market prices are often far above or far below intrinsic values. • The risk-adjusted return on one asset class can be far out of line with those of other asset classes. Because assets are often valued at other-than-fair prices, an asset class can deliver a risk-adjusted return that is significantly too high (a free lunch) or too low relative to other asset classes. • Some investors can consistently outperform others. Because of the existence of (a) significant misvaluations and (b) differences among participants in terms of skill, insight and information access, it is possible for misvaluations to be identified and profited from with regularity.

This last point is very important in terms of what it does and does not mean. Inefficient markets do not necessarily give their participants generous returns. Rather, it’s my view that they provide the raw material—mispricings—that can allow some people to win and others to lose on the basis of differential skill.

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In the great debate over efficiency versus inefficiency, I have concluded that no market is completely one or the other. It’s just a matter of degree. I wholeheartedly appreciate the opportunities that inefficiency can provide, but I also respect the concept of market efficiency, and I believe strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there.

In the end, I’ve come to an interesting resolution: Efficiency is not so universal that we should give up on superior performance. At the same time, efficiency is what lawyers call a “rebuttable presumption”—something that should be presumed to be true until someone proves otherwise. Therefore, we should assume that efficiency will impede our achievement unless we have good reason to believe it won’t in the present case.

Bottom line: Inefficiency is a necessary condition for superior investing. Attempting to outperform in a perfectly efficient market is like flipping a fair coin: the best you can hope for is fifty-fifty. For investors to get an edge, there have to be inefficiencies in the underlying process—imperfections, mispricings—to take advantage of.

Is investment theory, with its notion of market efficiency, the equivalent of a physical law that is universally true? Or is it an irrelevant ivory-tower notion to be disregarded? In the end, it’s a question of balance, and balance comes from applying informed common sense. The key turning point in my investment management career came when I concluded that because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.

To simplify (or oversimplify), all approaches to investing in company securities can be divided into two basic types: those based on analysis of the company’s attributes, known as “fundamentals,” and those based on study of the price behavior of the securities themselves. In other words, an investor has two basic choices: gauge the security’s underlying intrinsic value and buy or sell when the price diverges from it, or base decisions purely on expectations regarding future price movements.

I’ll turn to the latter first, since I don’t believe in it and should be able to dispose of it rather promptly. Technical analysis, or the study of past stock price behavior, has been practiced ever since I joined the industry (and well before that), but it’s been in decline.

It seems clear that momentum investing isn’t a cerebral approach to investing. The greatest example came in 1998–1999, with the rise of people called day traders. Most were nonprofessional investors drawn from other walks of life by the hope for easy money in the tech-media-telecom stock boom.

Moving away from momentum investors and their Ouija boards, along with all other forms of investing that eschew intelligent analysis, we are left with two approaches, both driven by fundamentals: value investing and growth investing. In a nutshell, value investors aim to come up with a security’s current intrinsic value and buy when the price is lower, and growth investors try to find securities whose value will increase rapidly in the future.

To value investors, an asset isn’t an ephemeral concept you invest in because you think it’s attractive (or think others will find it attractive). It’s a tangible object that should have an intrinsic value capable of being ascertained, and if it can be bought below its intrinsic value, you might consider doing so. Thus, intelligent investing has to be built on estimates of intrinsic value. Those estimates must be derived rigorously, based on all of the available information.

The quest in value investing is for cheapness. Value investors typically look at financial metrics such as earnings, cash flow, dividends, hard assets and enterprise value and emphasize buying cheap on these bases. The primary goal of value investors, then, is to quantify the company’s current value and buy its securities when they can do so cheaply.

Growth investing lies somewhere between the dull plodding of value investing and the adrenaline charge of momentum investing. Its goal is to identify companies with bright futures. That means by definition that there’s less emphasis on the company’s current attributes and more on its potential.