The Most Important Thing: Uncommon Sense for The Thoughtful Investor

by Howard Marks

“Experience is what you got when you didn’t get what you wanted.”

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

If your behavior is conventional, you’re likely to get conventional results—either good or bad. 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.

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.

One of the great sayings about poker is that “in every game there’s a fish. If you’ve played for 45 minutes and haven’t figured out who the fish is, then it’s you.” The same is certainly true of inefficient market investing.

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.

We all know that even if a coin has come up heads ten times in a row, the probability of heads on the next throw is still fifty-fifty. Likewise, the hypothesis says, the fact that a stock’s price has risen for the last ten days tells you nothing about what it will do 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.

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.

No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.

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.

All 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.

Trying to buy below value isn’t infallible, but it’s the best chance we have.

Riskier investments are those for which the outcome is less certain. That is, the probability distribution of returns is wider.

“There’s a big difference between probability and outcome. Probable things fail to happen— and improbable things happen— all the time.”

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.

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

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.

Investors will overvalue companies when they’re doing well and undervalue them when things get difficult.

When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.

Very early in my career, a veteran investor told me about the three stages of a bull market. Now I’ll share them with you. 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

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.

Superior investors know—and buy—when the price of something is lower than it should be. And the price of an investment can be lower than it should be only when most people don’t see its merit.

Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.

In short, there are two primary elements in superior investing: seeing some quality that others don’t see or appreciate (and that isn’t reflected in the price), and having it turn out to be true (or at least accepted by the market).

When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain. Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.

Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.

the macro-future—is guarded. Its adherents

In the world of investing, . . . nothing is as dependable as cycles. Fundamentals, psychology, prices and returns will rise and fall, presenting opportunities to make mistakes or to profit from the mistakes of others. They are the givens.

Several things go together for those who view the world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly; insistence on defensive investing; and emphasis on avoiding pitfalls. To me that’s what thoughtful investing is all about.

Defensive investing sounds very erudite, but I can simplify it: Invest scared! Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high-quality decisions but still be hit by bad luck or surprise events.

There are times when the investing errors are of omission: the things you should have done but didn’t. Today I think the errors are probably of commission: the things you shouldn’t have done but did. There are times for aggressiveness. I think this is a time for caution.

The best foundation for a successful investment—or a successful investment career—is value. You must have a good idea of what the thing you’re considering buying is worth.

The relationship between price and value holds the ultimate key to investment success. Buying below value is the most dependable route to profit. Paying above value rarely works out as well.