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

by Howard Marks

“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.

Quantification often lends excessive authority to statements that should be taken with a grain of salt.

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.

The point is, people usually expect the future to be like the past and underestimate the potential for change.

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.

Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we’ll continue to be alert for times when they don’t.

Regardless of what’s designed into market structures, risk will be low only if investors behave prudently.

The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.

Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior.

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all.

Robertson. In general their records are remarkable because of their decades of consistency and absence of disasters, not just their high returns.

Risk—the possibility of loss—is not observable. What is observable is loss, and loss generally happens only when risk collides with negative events.

Likewise, loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.

Likewise, an excellent investor may be one who—rather than reporting higher returns than others—achieves the same return but does so with less risk (or even achieves a slightly lower return with far less risk).

It’s an outstanding accomplishment to achieve the same return as the risk bearers and do so with less risk. But most of the time it’s a subtle, hidden accomplishment that can be appreciated only through sophisticated judgments.

Controlling the risk in your portfolio is a very important and worthwhile pursuit. The fruits, however, come only in the form of losses that don’t happen. Such what-if calculations are difficult in placid times.

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

It’s by bearing risk when we’re well paid to do so—and especially by taking risks toward which others are averse in the extreme—that we strive to add value for our clients.

I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero.

Rule number one: most things will prove to be cyclical. • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

Mechanical things can go in a straight line. Time moves ahead continuously. So can a machine when it’s adequately powered. But processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

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.

The next time you’re approached with a deal predicated on cycles having ceased to occur, remember that invariably that’s a losing bet.

This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.”

When investors in general are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-averse, prices can offer more return than risk.

• The first, when a few forward-looking people begin to believe things will get better • The second, when most investors realize improvement is actually taking place • The third, when everyone concludes things will get better forever

Most important, in the late stages of the great bull markets, people become willing to pay prices for stocks that assume the good times will go on ad infinitum.

Like a pendulum, the swing of investor psychology toward an extreme causes energy to build up that eventually will contribute to the swing back in the other direction.

The swing back from the extreme is usually more rapid—and thus takes much less time—than the swing to the extreme. (Or as my partner Sheldon Stone likes to say, “The air goes out of the balloon much faster than it went in.”)

Busts are the product of booms, and I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction.

Those who believe that the pendulum will move in one direction forever—or reside at an extreme forever—eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously.

Inefficiencies—mispricings, misperceptions, mistakes that other people make—provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes.

The first emotion that serves to undermine investors’ efforts is the desire for money, especially as it morphs into greed.

“Extreme brevity of the financial memory,” to use John Kenneth Galbraith’s wonderful phrase, keeps market participants from recognizing the recurring nature of these patterns, and thus their inevitability:

“many people who don’t share the consensus view of the market start to feel left out. Eventually it reaches a stage where it appears the really crazy people are those not in the market.”

The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing—these factors are near universal.

To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored.

As hard as it was for most people to resist buying in the tech bubble, it was even harder to resist selling—and still more difficult to buy—in the depths of the credit crisis.

insistence on acting as you should when price diverges from value,

enough conversance with past cycles—gained at first from reading and talking to veteran investors, and later through experience—to know that market excesses are ultimately punished, not rewarded,

willingness to look wrong while the market goes from misvalued to more misvalued (as it invariably will),

There’s only one way to describe most investors: trend followers. Superior investors are the exact opposite.

“The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”

The market rises as people switch from being sellers to being buyers, and as buyers become even more motivated and the sellers less so. (If buyers didn’t predominate, the market wouldn’t be rising.)

Figuratively speaking, a top occurs when the last person who will become a buyer does so. Since every buyer has joined the bullish herd by the time the top is reached, bullishness can go no further and the market is as high as it can go.

Since there’s no one left to turn bullish, the market stops going up. And if on the next day one person switches from buyer to seller, it will start to go down. • So at the extremes, which are created by what “most people” believe, most people are wrong. • Therefore, the key to investment success has to lie in doing the

What does this say about how we should act? Joining the herd and participating in the extremes of these cycles obviously can be dangerous to your financial health.

“Once-in-a-lifetime” market extremes seem to occur once every decade or so—not often enough for an investor to build a career around capitalizing on them. But attempting to do so should be an important component of any investor’s approach.

Just don’t think it’ll be easy. You need the ability to detect instances in which prices have diverged significantly from intrinsic value.

consensus thinking must be based on reason and analysis. You must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong.