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

by Howard Marks

Value investors buy stocks (even those whose intrinsic value may show little growth in the future) out of conviction that the current value is high relative to the current price. • Growth investors buy stocks (even those whose current value is low relative to their current price) because they believe the value will grow fast enough in the future to produce substantial appreciation. Thus, it seems to me, the choice isn’t really between value and growth, but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.

There’s no bright-line distinction between value and growth; both require us to deal with the future. Value investors think about the company’s potential for growth, and the “growth at a reasonable price” school pays explicit homage to value. It’s all a matter of degree. However, I think it can fairly be said that growth investing is about the future, whereas value investing emphasizes current-day considerations but can’t escape dealing with the future.

In general, the upside potential for being right about growth is more dramatic, and the upside potential for being right about value is more consistent. Value is my approach. In my book, consistency trumps drama.

And as one of the greatest investment adages reminds us, “Being too far ahead of your time is indistinguishable from being wrong.” So now that security worth 80 is priced at 50 instead of 60. What do you do?

An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse. This one statement shows how hard it is to get it all right.

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.

For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.

People may have bought into great companies, but they paid the wrong price.

Underlying fundamental value, of course, but most of the time a security’s price will be affected at least as much—and its short-term fluctuations determined primarily—by two other factors: psychology and technicals.

And that brings me to the second factor that exerts such a powerful influence on price: psychology. It’s impossible to overstate how important this is. In fact, it’s so vital that several later chapters are devoted to discussing investor psychology and how to deal with its manifestations.

Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.

Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge. The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.

For self-protection, then, you must invest the time and energy to understand market psychology.

Try to have psychology and technicals on your side as well.

bubbles start with some nugget of truth: • Tulips are beautiful and rare (in seventeenth-century Holland). • The Internet is going to change the world. • Real estate can keep up with inflation, and you can always live in a house.

In bubbles, infatuation with market momentum takes over from any notion of value and fair price, and greed (plus the pain of standing by as others make seemingly easy money) neutralizes any prudence that might otherwise hold sway.

as John Maynard Keynes pointed out, “The market can remain irrational longer than you can remain solvent.” Trying to buy below value isn’t infallible, but it’s the best chance we have.

Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.

First, risk is a bad thing, and most level-headed people want to avoid or minimize it. It is an underlying assumption in financial theory that people are naturally risk-averse, meaning they’d rather take less risk than more.

Second, when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return.

Third, when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well. Was the return achieved in safe instruments or risky ones?

Surely investors who get their statements and find that their accounts made 10 percent for the year don’t know whether their money managers did a good job or a bad one. In order to reach a conclusion, they have to have some idea about how much risk their managers took. In other words, they have to have a feeling for “risk-adjusted return.”

The traditional risk/return graph (figure 5.1) is deceptive because it communicates the positive connection between risk and return but fails to suggest the uncertainty involved. It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money. I hope my version of the graph is more helpful. It’s meant to suggest both the positive relationship between risk and expected return and the fact that uncertainty about the return and the possibility of loss increase as risk increases.

According to the academicians who developed capital market theory, risk equals volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition of risk.

Rather than volatility, I think people decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return. To me, “I need more upside potential because I’m afraid I could lose money” makes an awful lot more sense than “I need more upside potential because I’m afraid the price may fluctuate.” No, I’m sure “risk” is—first and foremost—the likelihood of losing money.

Falling short of one’s goal—Investors

Underperformance—Let’s

Career risk—This

Unconventionality—Along

Illiquidity—If

First, risk of loss does not necessarily stem from weak fundamentals.

Second, risk can be present even without weakness in the macroenvironment.

Mostly it comes down to psychology that’s too positive and thus prices that are too high.

also expect high returns from things that have been doing well lately. These souped-up investments may deliver on people’s expectations for a while, but they certainly entail high risk. Having been borne aloft on the crowd’s excitement and elevated to what I call the “pedestal of popularity,” they offer the possibility of continued high returns, but also of low or negative ones.

Theory says high return is associated with high risk because the former exists to compensate for the latter. But pragmatic value investors feel just the opposite: They believe high return and low risk can be achieved simultaneously by buying things for less than they’re w...

First, it clearly is nothing but a matter of opinion:

estimate. Second, the standard for quantification is nonexistent. With any given investment, some people will think the risk is high and others will think it’s low. Some will state it as the probability of not making money, and some as the probability of losing a given fraction of their money (and so forth). Some will think of it as the risk of losing money over one year, and some as the risk of losing money over the entire holding period. Clearly, even if all the investors involved met in a room and showed their cards, they’d never agree on a single number representing an investment’s riskiness. And even if they could, that number wouldn’t likely be capable of being compared against another number, set by another group of investors, for another investment. This is one of the reasons why I say risk and the risk/return decision aren’t “machinable,” or capable of being turned over to a computer.

The bottom line is that, looked at prospectively, much of risk is subjective, hidden and unquantifiable.

Given the difficulty of quantifying the probability of loss, investors who want some objective measure of risk-adjusted return—and they are many—can only look to the so-called Sharpe ratio.

A few years ago, while considering the difficulty of measuring risk prospectively, I realized that because of its latent, nonquantitative and subjective nature, the risk of an investment—defined as the likelihood of loss—can’t be measured in retrospect any more than it can a priori.

Fooled by Randomness, by Nassim Nicholas Taleb, is the authority on this subject as far as I’m concerned, and in it he talks about the “alternative histories” that could have unfolded but didn’t. There’s more about this important book in chapter 16, but at the moment I am interested in how the idea of alternative histories relates to risk.

Bruce has put it admirably into words: “There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” That’s one of the most important things you can know about investment risk.

The most common bell-shaped distribution is called the “normal” distribution. However, people often use the terms bell-shaped and normal interchangeably, and they’re not the same. The former is a general type of distribution, while the latter is a specific bell-shaped distribution with very definite statistical properties. Failure to distinguish between the two doubtless made an important contribution to the recent credit crisis.

Now that investing has become so reliant on higher math, we have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world. Quantification often lends excessive authority to statements that should be taken with a grain of salt. That creates significant potential for trouble.

For the most part, I think it’s fair to say that investment performance is what happens when a set of developments—geopolitical, macro-economic, company-level, technical and psychological—collide with an extant portfolio. Many futures are possible, to paraphrase Dimson, but only one future occurs. The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck.

Return alone—and especially return over short periods of time—says very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it. And yet, risk cannot be measured.

Decisions whether or not to bear risk are made in contemplation of normal patterns recurring, and they do most of the time. But once in a while, something very different happens.... Occasionally, the improbable does occur.

Finally and importantly, most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk ’s all about.

Whereas the theorist thinks return and risk are two separate things, albeit correlated, the value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices. Thus, awareness of the relationship between price and value—whether for a single security or an entire market—is an essential component of dealing successfully with risk.

Risk arises when markets go so high that prices imply losses rather than the potential rewards they should. Dealing with this risk starts with recognizing it.