The Most Important Thing: Uncommon Sense for The Thoughtful Investor

by Howard Marks

Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem.

Psychological and technical factors can swamp fundamentals.

Markets change, invalidating models.

Leverage magnifies outcomes but doesn’t add value.

Excesses correct.

Most of these eleven lessons can be reduced to just one: be alert to what’s going on around you with regard to the supply/demand balance for investable funds and the eagerness to spend them.

While it was nigh onto impossible to avoid declines completely, relative outperformance in the form of smaller losses was enough to let you do better in the decline and take greater advantage of the rebound.

Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery. This is the greatest error in investing—the most unfortunate aspect of pro-cyclical behavior—because of its permanence and because it tends to affect large portions of portfolios.

One way to improve investment results—which we try hard to apply at Oaktree—is to think about what “today’s mistake” might be and try to avoid it.

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.

When investor psychology is at equilibrium and fear and greed are balanced, asset prices are likely to be fair relative to value. In that case there may be no compelling action, and it’s important to know that, too. When there’s nothing particularly clever to do, the potential pitfall lies in insisting on being clever.

beta, a measure of a portfolio’s relative sensitivity to market movements. The other is alpha, which I define as personal investment skill, or the ability to generate performance that is unrelated to movement of the market.

returns don’t increase to compensate for risk other than systematic risk. Why don’t they? According to theory, the risk that markets compensate for is the risk that is intrinsic and inescapable in investing: systematic or “non-diversifiable” risk. The rest of risk comes from decisions to hold individual stocks: non-systematic risk. Since that risk can be eliminated by diversifying, why should investors be compensated with additional return for bearing it?

the formula for explaining portfolio perfor mance (y) is as follows: y= α +βx Here α is the symbol for alpha, β stands for beta, and x is the return of the market. The market-related return of the portfolio is equal to its beta times the market return, and alpha (skill-related return) is added to arrive at the total return

Investors who lack skill simply earn the return of the market and the dictates of their style. Without skill, aggressive investors move a lot in both directions, and defensive investors move little in either direction.

Only skill can be counted on to add more in propitious environments than it costs in hostile ones.

In good years in the market, it’s good enough to be average. Everyone makes money in the good years,

There is a time, however, when we consider it essential to beat the market, and that’s in the bad years.

If we’re consistently able to decline less when the market declines and also participate fully when the market rises, this can be attributable to only one thing: alpha, or skill.

To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them—ideally, all three.

Only a strong sense of value will give you the discipline needed to take profits on a highly appreciated asset that everyone thinks will rise nonstop, or the guts to hold and average down in a crisis even as prices go lower every day.

The superior investor never forgets that the goal is to find good buys, not good assets.

buying when price is below value is a key element in limiting risk. Neither paying up for high growth nor participating in a “hot” momentum market can do the same.

Most trends— both bullish and bearish—eventually become overdone, profiting those who recognize them early but penalizing the last to join.

while we never know where we’re going, we ought to know where we are. We can infer where markets stand in their cycle from the behavior of those around us. When other investors are unworried, we should be cautious; when investors are panicked, we should turn aggressive.

“Being too far ahead of your time is indistinguishable from being wrong.” It can require patience and fortitude to hold positions long enough to be proved right.

They have to reject increased risk bearing as a surefire formula for investment success and know that riskier investments entail a wider range of possible outcomes and a higher probability of loss.

While aggressive investing can produce exciting results when it goes right—especially in good times—it’s unlikely to generate gains as reliably as defensive investing.

Rather than just trying to do the right thing, the defensive investor places a heavy emphasis on not doing the wrong thing. Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in good times, investors must decide what balance to strike between the two.

An investor can obtain margin for error by insisting on tangible, lasting value in the here and now; buying only when price is well below value; eschewing leverage; and diversifying.

Few people if any know more than the consensus about what’s going to happen to the economy, interest rates and market aggregates. Thus, the investor’s time is better spent trying to gain a knowledge advantage regarding “the knowable”: industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don’t.

In both economic forecasting and investment management, it’s worth noting that there’s usually someone who gets it exactly right . . . but it’s rarely the same person twice. The most successful investors get things “about right” most of the time, and that’s much better than the rest.

For us to conclude that investors truly add value, we have to see how they perform in environments to which their style isn’t particularly well suited.