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

by Howard Marks

You can’t do the same things others do and expect to outperform. . . . Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently. I conceptualize the situation as a simple 2-by-2 matrix:

• You can’t make a career out of buying from forced sellers and selling to forced buyers; they’re not around all the time, just on rare occasions at the extremes of crises and bubbles. • Since buying from a forced seller is the best thing in our world, being a forced seller is the worst. That means it’s essential to arrange your affairs so you’ll be able to hold on—and not sell—at the worst of times. This requires both long-term capital and strong psychological resources.

people should like something less when its price rises, but in investing they often like it more.

• The positives behind stocks can be genuine and still produce losses if you overpay for them. • Those positives—and the massive profits that seemingly everyone else is enjoying—can eventually cause those who have resisted participating to capitulate and buy. • A “top” in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments. • “Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time . . . or become far more so. • Eventually, though, valuation has to matter.

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. The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many “alternative histories” that were possible.

Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.

Like opportunities to make money, the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions.

Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion.

Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as their psychology strengthens and they become bolder and less worried, investors cease to demand adequate risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.

When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.

Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.

Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.

Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. They reverse (rather than going on forever) because trends create the reasons for their own reversal. Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.

When the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. (John Kenneth Galbraith, A Short History of Financial Euphoria [New York: Viking, 1990])

Learn to see them for what they are; that’s the first step toward gaining the courage to resist. And be realistic. Investors who believe they’re immune to the forces described in this chapter do so at their own peril. If they influence others enough to move whole markets, why shouldn’t they affect you, too? If a bull case is so powerful that it can make adults overlook elevated valuations and deny the impossibility of the perpetual-motion machine, why shouldn’t it have the same influence on you?

The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.

“investment is the discipline of relative selection.”

The key during a crisis is to be (a) insulated from the forces that require selling and (b) positioned to be a buyer instead. To satisfy those criteria, an investor needs the following things: staunch reliance on value, little or no use of leverage, long-term capital and a strong stomach.