The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor by Howard Marks. If you are an amateur or a professional investor, it would be a great idea to re-read this book every year to get some "mental clarity." If you are not into investing but troubled by the insanity around you then you too can meditate on this book.
The Most Important Thing Is . . . Second Level Thinking:
Second-level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account:
Efficiency is not so universal that we should give up on superior performance. At the same time, efficiency is what lawyers call a “rebuttable presumption”— something that should be presumed to be true until someone proves otherwise. Therefore, we should assume that efficiency will impede our achievement unless we have good reason to believe it won’t in the present case.
The Most Important Thing Is . . . Value
The best candidate for that something tangible is fundamentally derived intrinsic value. An accurate estimate of intrinsic value is the essential foundation for steady, unemotional and potentially profitable investing.
The Most Important Thing Is . . . The Relationship Between Price and Value:
People should like something less when its price rises, but in investing they often like it more. And what of that other infamous “can’t lose” idea? In the tech bubble, buyers didn’t worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it. Unfortunately, the greater fool theory works only until it doesn’t. Valuation eventually comes into play, and those who are holding the bag when it does have to face the music.
Buying something for less than its value. In my opinion, this is what it’s all about— the most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market’s functioning properly, value exerts a magnetic pull on price.
The Most Important Thing Is . . . Understanding/Recognizing/Controlling Risk:
There are many kinds of risk…. But volatility may be the least relevant of them all. Theory says investors demand more return from investments that are more volatile. But for the market to set the prices for investments such that more volatile investments will appear likely to produce higher returns, there have to be people demanding that relationship, and I haven’t met them yet. I’ve never heard anyone at Oaktree— or anywhere else, for that matter— say, “I won’t buy it, because its price might show big fluctuations,” or “I won’t buy it, because it might have a down quarter.” Thus, it’s hard for me to believe volatility is the risk investors factor in when setting prices and prospective returns. Rather than volatility, 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, I’m sure “risk” is— first and foremost— the likelihood of losing money.
“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.The market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the “perversity of risk.” When investors feel risk is high, their actions serve to reduce risk. But when investors believe risk is low, they create dangerous conditions. The market is dynamic rather than static, and it behaves in ways that are counterintuitive.
Great investors are those who take risks that are less than commensurate with the returns they earn. They may produce moderate returns with low risk, or high returns with moderate 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.
The Most Important Thing Is . . . Being Attentive to Cycles:
The process is simple: The economy moves into a period of prosperity. Providers of capital thrive, increasing their capital base. Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk. Risk averseness disappears. Financial institutions move to expand their businesses— that is, to provide more capital. They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction and easing covenants.
When this point is reached, the up-leg described above— the rising part of the cycle— is reversed. Losses cause lenders to become discouraged and shy away. Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements. Less capital is made available— and at the trough of the cycle, only to the most qualified of borrowers, if anyone. Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies. This process contributes to and reinforces the economic contraction.
The Most Important Thing Is . . . Awareness of the Pendulum:
The market has a mind of its own, and it’s changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves like a pendulum.
There are a few things of which we can be sure, and this is one: Extreme market behavior will reverse. 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.
The Most Important Thing Is . . . Combating Negative Influences:
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.
Finally, I want to mention a phenomenon I call capitulation, a regular feature of investor behavior late in cycles. Investors hold to their convictions as long as they can, but when the economic and psychological pressures become irresistible, they surrender and jump on the bandwagon.
The Most Important Thing Is . . . Contrarianism:
“Buy low; sell high” is the time-honored dictum, but investors who are swept up in market cycles too often do just the opposite. The proper response lies in contrarian behavior: buy when they hate ’em, and sell when they love ’em. “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. You have to have a strong-enough stomach to defy conventional wisdom (one of the greatest oxymorons) and resist the myth that the market’s always efficient and thus right.
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). It should be clear from the first element that the process has to begin with investors who are unusually perceptive, unconventional, iconoclastic or early. That’s why successful investors are said to spend a lot of their time being lonely.
The Most Important Thing Is . . . Finding Bargains:
The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of :
The Most Important Thing Is . . . Patient Opportunism:
The key during a crisis is to be:
The Most Important Thing Is . . . Knowing What You Don't Know:
One key question investors have to answer is whether they view the future as knowable or unknowable. Investors who feel they know what the future holds will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth— in other words, doing things that in the absence of foreknowledge would increase risk.
On the other hand, 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. The first group of investors did much better in the years leading up to the crash. But the second group was better prepared when the crash unfolded, and they had more capital available (and more-intact psyches) with which to profit from purchases made at its nadir.
The Most Important Thing Is . . . Having a Sense for Where We Stand:
It would be wonderful to be able to successfully predict the swings of the pendulum and always move in the appropriate direction, but this is certainly an unrealistic expectation. I consider it far more reasonable to try to:
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.
Taleb’s view of an uncertain world is much more consistent with mine. Everything I believe and recommend about investing proceeds from that school of thought. 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. Given that we don’t know exactly which future will obtain, we have to get value on our side by having a strongly held, analytically derived opinion of it and buying for less when opportunities to do so present themselves. We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones. To improve our chances of success, we have to emphasize acting contrary to the herd when it’s at extremes, being aggressive when the market is low and cautious when it’s high. Given the highly indeterminate nature of outcomes, we must view strategies and their results— both good and bad— with suspicion until proved out over a large number of trials.
The Most Important Thing Is . . . Investing Defensively:
There are two principal elements in investment defense. The first is the exclusion of losers from portfolios. This is best accomplished by conducting extensive due diligence, applying high standards, demanding a low price and generous margin for error (see later in this chapter) and being less willing to bet on continued prosperity, rosy forecasts and developments that maybe uncertain. The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes. In addition to the ingredients described previously that help keep individual losing investments from the portfolio, this aspect of investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.
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. 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. And if nothing does go wrong, surely the winners will take care of themselves.
The Most Important Thing Is . . . Avoiding Pitfalls:
Too much capital availability makes money flow to the wrong places. When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error.
The Most Important Thing Is . . . Adding Value:
In good years in the market, it’s good enough to be average. Everyone makes money in the good years, and I have yet to hear anyone explain convincingly why it’s important to beat the market when the market does well. No, in the good years average is good enough. There is a time, however, when we consider it essential to beat the market, and that’s in the bad years. Our clients don’t expect to bear the full brunt of market losses when they occur, and neither do we. Thus, it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious. In order to stay up with the market when it does well, a portfolio has to incorporate good measures of beta and correlation with the market. But if we’re aided by beta and correlation on the way up, shouldn’t they be expected to hurt us on the way down? 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. That’s an example of value-added investing, and if demonstrated over a period of decades, it has to come from investment skill.
The Most Important Thing Is . . . Reasonable Expectations:
One of the six tenets of our investment philosophy calls for “disavowal of market timing.” Yet we expend a lot of effort to diagnose the market environment, and we certainly don’t invest regardless of what we think the environment implies for risk and return. Rather, our disinterest in market timing means— above all else— that if we find something attractive, we never say, “It’s cheap today, but we think it’ll be cheaper in six months, so we’ll wait.” It’s just not realistic to expect to be able to buy at the bottom.
I encourage you to think about “good-enough returns.” It’s essential to realize that there are returns so high that they aren’t worth going for and risks that aren’t worth taking.
The Most Important Thing Is . . . Second Level Thinking:
Second-level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account:
- What is the range of likely future outcomes?
- Which outcome do I think will occur?
- What’s the probability I’m right?
- What does the consensus think?
- How does my expectation differ from the consensus?
- How does the current price for the asset comport with the consensus view of the future, and with mine?
- Is the consensus psychology that’s incorporated in the price too bullish or bearish?
- What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
Efficiency is not so universal that we should give up on superior performance. At the same time, efficiency is what lawyers call a “rebuttable presumption”— something that should be presumed to be true until someone proves otherwise. Therefore, we should assume that efficiency will impede our achievement unless we have good reason to believe it won’t in the present case.
- Respect for efficiency says that before we embark on a course of action, we should ask some questions: have mistakes and mispricings been driven out through investors’ concerted efforts, or do they still exist, and why?
- Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that’s too cheap?
- If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk?
- Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
- Do you really know more about the asset than the seller does?
- If it’s such a great proposition, why hasn’t someone else snapped it up?
The Most Important Thing Is . . . Value
The best candidate for that something tangible is fundamentally derived intrinsic value. An accurate estimate of intrinsic value is the essential foundation for steady, unemotional and potentially profitable investing.
The Most Important Thing Is . . . The Relationship Between Price and Value:
People should like something less when its price rises, but in investing they often like it more. And what of that other infamous “can’t lose” idea? In the tech bubble, buyers didn’t worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it. Unfortunately, the greater fool theory works only until it doesn’t. Valuation eventually comes into play, and those who are holding the bag when it does have to face the music.
Buying something for less than its value. In my opinion, this is what it’s all about— the most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market’s functioning properly, value exerts a magnetic pull on price.
The Most Important Thing Is . . . Understanding/Recognizing/Controlling Risk:
There are many kinds of risk…. But volatility may be the least relevant of them all. Theory says investors demand more return from investments that are more volatile. But for the market to set the prices for investments such that more volatile investments will appear likely to produce higher returns, there have to be people demanding that relationship, and I haven’t met them yet. I’ve never heard anyone at Oaktree— or anywhere else, for that matter— say, “I won’t buy it, because its price might show big fluctuations,” or “I won’t buy it, because it might have a down quarter.” Thus, it’s hard for me to believe volatility is the risk investors factor in when setting prices and prospective returns. Rather than volatility, 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, I’m sure “risk” is— first and foremost— the likelihood of losing money.
“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.The market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the “perversity of risk.” When investors feel risk is high, their actions serve to reduce risk. But when investors believe risk is low, they create dangerous conditions. The market is dynamic rather than static, and it behaves in ways that are counterintuitive.
Great investors are those who take risks that are less than commensurate with the returns they earn. They may produce moderate returns with low risk, or high returns with moderate 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.
The Most Important Thing Is . . . Being Attentive to Cycles:
The process is simple: The economy moves into a period of prosperity. Providers of capital thrive, increasing their capital base. Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk. Risk averseness disappears. Financial institutions move to expand their businesses— that is, to provide more capital. They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction and easing covenants.
When this point is reached, the up-leg described above— the rising part of the cycle— is reversed. Losses cause lenders to become discouraged and shy away. Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements. Less capital is made available— and at the trough of the cycle, only to the most qualified of borrowers, if anyone. Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies. This process contributes to and reinforces the economic contraction.
The Most Important Thing Is . . . Awareness of the Pendulum:
The market has a mind of its own, and it’s changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves like a pendulum.
There are a few things of which we can be sure, and this is one: Extreme market behavior will reverse. 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.
The Most Important Thing Is . . . Combating Negative Influences:
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.
Finally, I want to mention a phenomenon I call capitulation, a regular feature of investor behavior late in cycles. Investors hold to their convictions as long as they can, but when the economic and psychological pressures become irresistible, they surrender and jump on the bandwagon.
The Most Important Thing Is . . . Contrarianism:
“Buy low; sell high” is the time-honored dictum, but investors who are swept up in market cycles too often do just the opposite. The proper response lies in contrarian behavior: buy when they hate ’em, and sell when they love ’em. “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. You have to have a strong-enough stomach to defy conventional wisdom (one of the greatest oxymorons) and resist the myth that the market’s always efficient and thus right.
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). It should be clear from the first element that the process has to begin with investors who are unusually perceptive, unconventional, iconoclastic or early. That’s why successful investors are said to spend a lot of their time being lonely.
The Most Important Thing Is . . . Finding Bargains:
The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of :
- a list of potential investments
- estimates of their intrinsic value
- a sense for how their prices compare with their intrinsic value, and
- an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.
The Most Important Thing Is . . . Patient Opportunism:
The key during a crisis is to be:
- insulated from the forces that require selling and
- positioned to be a buyer instead.
The Most Important Thing Is . . . Knowing What You Don't Know:
One key question investors have to answer is whether they view the future as knowable or unknowable. Investors who feel they know what the future holds will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth— in other words, doing things that in the absence of foreknowledge would increase risk.
On the other hand, 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. The first group of investors did much better in the years leading up to the crash. But the second group was better prepared when the crash unfolded, and they had more capital available (and more-intact psyches) with which to profit from purchases made at its nadir.
The Most Important Thing Is . . . Having a Sense for Where We Stand:
It would be wonderful to be able to successfully predict the swings of the pendulum and always move in the appropriate direction, but this is certainly an unrealistic expectation. I consider it far more reasonable to try to:
- stay alert for occasions when a market has reached an extreme
- adjust our behavior in response and
- most important, refuse to fall into line with the herd behavior that renders so many investors dead wrong at tops and bottoms.
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.
Taleb’s view of an uncertain world is much more consistent with mine. Everything I believe and recommend about investing proceeds from that school of thought. 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. Given that we don’t know exactly which future will obtain, we have to get value on our side by having a strongly held, analytically derived opinion of it and buying for less when opportunities to do so present themselves. We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones. To improve our chances of success, we have to emphasize acting contrary to the herd when it’s at extremes, being aggressive when the market is low and cautious when it’s high. Given the highly indeterminate nature of outcomes, we must view strategies and their results— both good and bad— with suspicion until proved out over a large number of trials.
The Most Important Thing Is . . . Investing Defensively:
There are two principal elements in investment defense. The first is the exclusion of losers from portfolios. This is best accomplished by conducting extensive due diligence, applying high standards, demanding a low price and generous margin for error (see later in this chapter) and being less willing to bet on continued prosperity, rosy forecasts and developments that maybe uncertain. The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes. In addition to the ingredients described previously that help keep individual losing investments from the portfolio, this aspect of investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.
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. 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. And if nothing does go wrong, surely the winners will take care of themselves.
The Most Important Thing Is . . . Avoiding Pitfalls:
Too much capital availability makes money flow to the wrong places. 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.
- Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem.
- Psychological and technical factors can swamp fundamentals.
- Leverage magnifies outcomes but doesn’t add value.
The Most Important Thing Is . . . Adding Value:
In good years in the market, it’s good enough to be average. Everyone makes money in the good years, and I have yet to hear anyone explain convincingly why it’s important to beat the market when the market does well. No, in the good years average is good enough. There is a time, however, when we consider it essential to beat the market, and that’s in the bad years. Our clients don’t expect to bear the full brunt of market losses when they occur, and neither do we. Thus, it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious. In order to stay up with the market when it does well, a portfolio has to incorporate good measures of beta and correlation with the market. But if we’re aided by beta and correlation on the way up, shouldn’t they be expected to hurt us on the way down? 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. That’s an example of value-added investing, and if demonstrated over a period of decades, it has to come from investment skill.
The Most Important Thing Is . . . Reasonable Expectations:
One of the six tenets of our investment philosophy calls for “disavowal of market timing.” Yet we expend a lot of effort to diagnose the market environment, and we certainly don’t invest regardless of what we think the environment implies for risk and return. Rather, our disinterest in market timing means— above all else— that if we find something attractive, we never say, “It’s cheap today, but we think it’ll be cheaper in six months, so we’ll wait.” It’s just not realistic to expect to be able to buy at the bottom.
I encourage you to think about “good-enough returns.” It’s essential to realize that there are returns so high that they aren’t worth going for and risks that aren’t worth taking.
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