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

by Howard Marks

“Experience is what you got when you didn’t get what you wanted.” Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times.

it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.

In my view, that’s the definition of successful investing: doing better than the market and other investors.

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.

First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”

• First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”

First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and ...

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

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

Only if your behavior is unconventional is your performance likely to be unconventional, and only if your judgments are superior is your performance likely to be above average.

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.

According to investment theory, people are risk-averse by nature, meaning that in general they’d rather bear less risk than more.

In fact, some asset classes are quite efficient. In most of these: • the asset class is widely known and has a broad following; • the class is socially acceptable, not controversial or taboo; • the merits of the class are clear and comprehensible, at least on the surface ; and • information about the class and its components is distributed widely and evenly. If these conditions are met, there’s no reason why the asset class should systematically be overlooked, misunderstood or underrated.

Is it possible for any one person to systematically know much more about these things than everyone else? Probably not. And if not, then no one should be able to regularly achieve above-average risk-adjusted returns through currency trading.

Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both. They are on the alert for instances of misperception. My son Andrew is a budding investor, and he comes up with lots of appealing investment ideas based on today’s facts and the outlook for tomorrow. But he’s been well trained. His first test is always the same: “And who doesn’t know that?”

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.

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.

For every person who gets a good buy in an inefficient market, someone else sells too cheap.

Therefore, we should assume that efficiency will impede our achievement unless we have good reason to believe it won’t in the present case.

If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk?

If it’s such a great proposition, why hasn’t someone else snapped it up?

just because efficiencies exist today doesn’t mean they’ll remain forever.

Abstention on the part of those who won’t venture in creates opportunities for those who will.

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.

In short, I think theory should inform our decisions but not dominate them.

But swallowing theory whole can make us give up on finding bargains, turn the process over to a computer and miss out on the contribution skillful individuals can make.

“Isn’t that a $10 bill lying on the ground?” asks the student. “No, it can’t be a $10 bill,” answers the professor. “If it were, someone would have picked it up by now.” The professor walks away, and the student picks it up and has a beer. “WHAT’S IT ALL ABOUT, ALPHA?” JULY 11, 2001

“if something cannot go on forever, it will stop.”

Growth investing lies somewhere between the dull plodding of value investing and the adrenaline charge of momentum investing.

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.

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.

in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away.

“Being too far ahead of your time is indistinguishable from being wrong.”

This makes it very difficult to hold, and to buy more at lower prices (which investors call “averaging down”), especially if the decline proves to be extensive.

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.

there’s nothing better than buying from someone who has to sell regardless of price during a crash.

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.

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.

It’s an extreme rendition of the phenomenon I described earlier: people should like something less when its price rises, but in investing they often like it more.

To sum up, I believe that an investment approach based on solid value is the most dependable. In contrast, counting on others to give you a profit regardless of value—relying on a bubble—is probably the least.

anything a better investment or increase the probability of gains. It merely magnifies whatever gains or losses may materialize.

Buying something for less than its value. In my opinion, this is what it’s all about—the most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market’s functioning properly, value exerts a magnetic pull on price.

But you’re unlikely to succeed for long if you haven’t dealt explicitly with risk. The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it.

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.”

Riskier investments are those for which the outcome is less certain.

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

Was it risky? Who knows? Perhaps it exposed you to great potential uncertainties that didn’t materialize.

fact that something—in this case, loss—happened doesn’t mean it was bound to happen, and the fact that something didn’t happen doesn’t mean it was unlikely.

you recall the opening sentence of this chapter: Investing consists of exactly one thing: dealing with the future. Yet clearly it’s impossible to “know” anything about the future.