The Most Important Thing: Uncommon Sense for The Thoughtful Investor

by Howard Marks

those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.

Maybe Mark Twain put it best: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

superior results in investing come from knowing more than others, and it hasn’t been demonstrated to my satisfaction that a lot of people know more than the consensus about the timing and extent of future cycles.

We may never know where we’re going, but we’d better have a good idea where we are. That is, even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.

I consider it far more reasonable to try to (a) stay alert for occasions when a market has reached an extreme, (b) adjust our behavior in response and, (c) most important, refuse to fall into line with the herd behavior that renders so many investors dead wrong at tops and bottoms.

So look around, and ask yourself: Are investors optimistic or pessimistic? Do the media talking heads say the markets should be piled into or avoided? Are novel investment schemes readily accepted or dismissed out of hand? Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls? Has the credit cycle rendered capital readily available or impossible to obtain? Are price/earnings ratios high or low in the context of history, and are yield spreads tight or generous? All of these things are important, and yet none of them entails forecasting.

The seven scariest words in the world for the thoughtful investor—too much money chasing too few deals—

In the years 2004–2007, the notion arose that if you cut risk into small pieces and sell the pieces off to investors best suited to hold them, the risk disappears.

$10 million earned through Russian roulette does not have the same value as $10 million earned through the diligent and artful practice of dentistry.

I always say the keys to profit are aggressiveness, timing and skill, and someone who has enough aggressiveness at the right time doesn’t need much skill.

Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof).

it’s essential to have a large number of observations— lots of years of data— before judging a given manager’s ability.

the things that happened are only a small subset of the things that could have happened.

Maybe what ultimately made the decision a success was a completely unlikely event, something that was just a matter of luck. In that case that decision—as successful as it turned out to be—may have been unwise, and the many other histories that could have happened would have shown the error of the decision.

the quality of a decision is not determined by the outcome. The events that transpire afterward make decisions successful or unsuccessful, and those events are often well beyond anticipating.

A good decision is one that a logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known.

In the long run, there’s no reasonable alternative to believing that good decisions will lead to investment profits. In the short run, however, we must be stoic when they don’t.

Short-term gains and short-term losses are potential impostors, as neither is necessarily indicative of real investment ability (or the lack thereof

The actions of the “I know” school are based on a view of a single future that is knowable and conquerable. My “I don’t know” school thinks of future events in terms of a probability distribution.

We should spend our time trying to find value among the knowable— industries, companies and securities—rather than base our decisions on what we expect from the less-knowable macro world of economies and broad market performance.

It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.

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.

The problem is that you can’t simultaneously go all out for both profit making and loss avoidance. Each investor has to take a position regarding these two goals, and usually that requires striking a reasonable balance.

professional tennis is a “winner’s game,” in which the match goes to the player who’s able to hit the most winners:

the tennis the rest of us play is a “loser’s game,” with the match going to the player who hits the fewest losers.

the pursuit of winners in the mainstream stock markets is unlikely to pay off for the investor. Instead, you should try to avoid hitting losers.

The choice between offense and defense investing should be based on how much the investor believes is within his or her control. In my view, investing entails a lot that isn’t.

Oaktree portfolios are set up to outperform in bad times, and that’s when we think outperformance is essential.

Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.

Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.

There are two principal elements in investment defense. The first is the exclusion of losers from portfolios.

The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes.

“Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in the good times, investors must choose between the two.”

Low price is the ultimate source of margin for error.

distinguishing yourself as a bond investor isn’t a matter of which paying bonds you hold, but largely of whether you’re able to exclude bonds that don’t pay. According to Graham and Dodd, this emphasis on exclusion makes fixed income investing a negative art.

One of the investor’s first and most fundamental decisions has to be on the question of how far out the portfolio will venture. How much emphasis should be put on diversifying, avoiding loss and ensuring against below-pack performance, and how much on sacrificing these things in the hope of doing better?

in order for something to be able to materially help your return if it succeeds, you have to do enough so that it could materially hurt you if it fails.

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. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong.

An investor needs do very few things right as long as he avoids big mistakes.

I think of the sources of error as being primarily analytical/intellectual or psychological/emotional.

want to spend some time on, however, is what I call “failure of imagination.” By that I mean either being unable to conceive of the full range of possible outcomes or not fully understanding the consequences of the more extreme occurrences.

Relying to excess on the fact that something “should happen” can kill you when it doesn’t.

few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third.

So failure of imagination consists in the first instance of not anticipating the possible extremeness of future events, and in the second instance of failing to understand the knock-on consequences of extreme events.

What We Learn from a Crisis—or Ought To Too much capital availability makes money flow to the wrong places.

When capital goes where it shouldn’t, bad things happen.

When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error.

Widespread disregard for risk creates great risk.

Inadequate due diligence leads to investment losses.

In heady times, capital is devoted to innovative investments, many of which fail the test of time.