The Most Important Thing: Uncommon Sense for The Thoughtful Investor

by Howard Marks

I spend more time discussing risk and how to limit it than how to achieve investment returns. To me, risk is the most interesting, challenging and essential aspect of investing.

Charley Ellis’s great article “The Loser’s Game” (The Financial Analysts Journal, July-August 1975), A Short History of Financial Euphoria, by John Kenneth Galbraith (New York: Viking, 1990) and Nassim Nicholas Taleb’s Fooled by Randomness (New York: Texere, 2001).

definition of successful investing: doing better than the market and other investors.

Second-level thinking is deep, complex and convoluted.

First-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. By definition, this can’t be the route to superior results. All investors can’t beat the market since, collectively, they are the market.

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

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.

The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.

many people are misled into believing that everyone can be a successful investor. Not everyone can. But the good news is that the prevalence of first-level thinkers increases the returns available to second-level thinkers.

The bottom line for me is that, although the more efficient markets often misvalue assets, it’s not easy for any one person—working with the same information as everyone else and subject to the same psychological influences—to consistently hold views that are different from the consensus and closer to being correct. That’s what makes the mainstream markets awfully hard to beat—even if they aren’t always right.

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?”

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.

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.

an accurate estimate of value is the indispensable starting point.

“net-net investing,” in which people buy when the total market value of a company’s stock is less than the amount by which the company’s current assets—such as cash, receivables and inventories—exceed its total liabilities. In this case, in theory, you could buy all the stock, liquidate the current assets, pay off the debts, and end up with the business and some cash.

Even a promising net-net investment can be doomed if the company’s assets are squandered on money-losing operations or unwise acquisitions.

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.

If you’ve settled on the value approach to investing and come up with an intrinsic value for a security or asset, the next important thing is to hold it firmly. That’s because in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away.

An accurate estimate of intrinsic value is the essential foundation for steady, unemotional and potentially profitable investing.

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.

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

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.

When the market’s functioning properly, value exerts a magnetic pull on price.

“The market can remain irrational longer than you can remain solvent.”

risk is a bad thing, and most level-headed people want to avoid or minimize it.

when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well.

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.

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,

since many of the best investors stick most strongly to their approach—and since no approach will work all the time—the best investors can have some of the greatest periods of underperformance.

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

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

even after an investment has been closed out, it’s impossible to tell how much risk it entailed.

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.

Return alone—and especially return over short periods of time—says very little about the quality of investment decisions.

Risk can be judged only by sophisticated, experienced second-level thinkers.

In theory, one thing that distinguishes humans from other species is that we can figure out that something’s dangerous without experiencing it.

in bullish times, people tend not to perform this function. Rather than recognize risk ahead, they tend to overestimate their ability to understand how new financial inventions will work.

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...

The received wisdom is that risk increases in the recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions.

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

Whether it be an individual security or other asset that is overrated and thus overpriced, or an entire market that’s been borne aloft by bullish sentiment and thus is sky-high, participating when prices are high rather than shying away is the main source of risk.

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.

There are few things as risky as the widespread belief that there’s no risk, because it’s only when investors are suitably risk-averse that prospective returns will incorporate appropriate risk premiums.

the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions.

only when investors are sufficiently risk-averse will markets offer adequate risk premiums.

“It’s only when the tide goes out that you find out who’s been swimming naked.”

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

The truth is, the herd is wrong about risk at least as often as it is about return.