Originally posted HERE as a series.
1. The Most Important Thing Is… Second Level Thinking
Howard Marks talks about second level thinking as being unconventional, intuitive and adaptive in a deep, complex, and convoluted manner. A second level thinker takes many different outcomes into account asking questions like, how do my expectations differ from the consensus or which outcomes are likely to occur versus the probability of others. In a sense it is thinking about what others are thinking, their beliefs, and possible actions that may ensue from them. It is having a perspective about other participants perspectives asking why, how and what constantly. It is simple, all investors can’t beat the market since, collectively, they are the market. Howard uses a simple example of different and better thinking summing up second level thinking. An investor may go out a step further thinking abstractly about the biases and influences that are present, influencing his attitude. Humans have a cause-and-effect relationship with one another and no simple rule works always, outcomes may or may not be rational, like economics, investing is an art and the key is to think at a second level.
|Howard Marks 2-by-2 Matrix||Conventional Behavior||Unconventional Behavior|
|Favorable Outcomes||Average Good Results||Above-average Results|
|Unfavorable Outcomes||Average Bad Results||Below-average Results|
“To outperform the average investor, you have to be able to outthink the consensus. Are you capable of doing so? What makes you think so?”
2. The Most Important Thing Is… Understanding Market Efficiency (and Its Limitations)
Under the efficient market theory there are certain assumptions made like, many investors are hard at work, they are all intelligent, objective, motivated and well equipped. They have equal access to available information and they are all open to buying, selling, or shorting any or every asset. This simply is not the case for all investors. The institutional portfolio managers are assigned and confined to various asset classes, investment styles, or niches. As Howard puts it,“Many of the best bargains at any point in time are found among the things other investors can’t or won’t do.” Although there are many smart people involved in creating the market and it is viewed as efficient most of the time, there are times where it is not, whether in certain asset classes, a single bargain, or in it’s entirety.
Howard has the view it should be looked at in a second level:
A) 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 is too cheap?
B) If the return appears so generous in proportion to risk, might you be overlooking some hidden risk?
C) Why would the seller of the asset be willing to part with it at a price from which you will receive an excessive return?
D) Do you really know more about the asset than the seller does?
To sum up the efficient market theory there is a story involving a finance professor and his student having a walk.
“Isn’t that a $10 bill laying on the ground?” asks the student. “No, it can’t be a $10 bill,” answers the professor. “If it were, someone would have picked it up by now.” The teacher walks away and the student picked it up and walked off to the pub for a cold beer.
3. The Most Important Thing Is… Value
“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. Like wise the fact that a stock’s price has risen for the last ten days tells you nothing about what it will do tomorrow.”
Now what is it that makes a company or underlying security valuable? It is the patents, brand names, equipment, buildings, land, human capital, financial resources, growth potential or ability to produce earnings and cash flow? Most would say it is of all the inputs above working in combination to produce earnings, although a liquidation value would also be present. Sometimes this is known as negative enterprise value or a “net-net” (popularized by Ben Graham) and is when a company’s short-term assets are of more value after paying all liabilities than the market quoted capitalization. The 1950’s were known for these types of investment when businesses share prices would advance on news of closing and liquidation, also known as “Worth more dead than alive.” Although, one must be able to distinguish between value of today and value of tomorrow. One must also hold a firm view on intrinsic value to cope with the disconnect that is present or may become present in the market.
Howard also says that being to early is indistinguishable from being wrong and that averaging down is how value investors make their biggest returns when a firm sense of intrinsic value and confidence in ones thesis is present. The final matter that is quite obvious, is that you also have to be right.
“An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.”
4. The Most Important Thing Is… The Relationship Between Price and Value
“Investment success doesn’t come from buying good things but rather from buying things well.” No asset is entitled to a high return and it is only attractive if it is priced right.
Due to the nature of the investment business there will be opportunities where people are both forced sellers and forced buyers. Examples of forced buying may be closet indexers or managers attempting to emulate an index fund or other fund managers that receive inflows of capital and must put it to work regardless of price. An example of a forced seller is when investors or managers are levered up on margin and when losses start to accumulate margin calls are made, if liquidity is not sufficient, forced selling occurs. Simply speaking these opportunities do not present themselves on a regular basis and are unpredictable in their very nature, thus a career cannot be made from them. Having psychology on your side and understanding or at the very least, attempting to understand other investor’s minds and motives, may provide valuable insight that can be found no where else.
The exact opposite of value investing would be aimlessly chasing bubbles with no thought of risk, only potential profit on the mind. A few examples of bubbles include: South Sea, Tulips, The Internet and Real Estate. As Howard Marks had put it “Buying something for less than its value. In my opinion is what it is 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 is functioning properly, value exerts a magnetic pull on price.”
5. The Most Important Thing Is… Understanding Risk
Some may view risk as the divergence of expected or probable outcomes from potential outcomes. Although finance theory defines risk as volatility or deviation this does not make sense to me. I view risk as inescapable and relating to capital allocation, the potential or probability of a permanent capital loss. When prices are high in relation to intrinsic value, yet an investor still participates, this is a main source of risk.
“Risk means more things can happen than will happen.” – Elroy Dimson
The following chart is from “The Most Important Thing” by Howard Marks depicting the “capital market line” with a twist. It includes bands of probability of essentially bell curves plotted on the traditional capital market line. This removes the auspicious and deceptive assumption that taking more risk leads to more returns. This cannot be further from the truth, if riskier investments reliably produced higher returns, they would not be riskier.
But what is risk? How can it be defined objectively? Intellects most likely chose volatility as an objective measure that may be extrapolated into the future for modeling purposes. However what if potential uncertainties did not materialize and the person was right for the wrong reasons? Tail events that occur once in a generation may cripple an investor that was protected to a degree of 99% or to the other extreme, a speculator may hit a once in a generation long shot making millions or billions by betting on tail events that are unlikely to materialize. The on lookers view the prior as risky and possibly aggressive and the latter as exceptional foresight. Many assumptions are also based on “as worse as the past” but what if the future disasters exceed the past, which more often then not, they do.
Many futures are possible but only one future occurs. The future is unpredictable and worst case scenarios often surpassed with very few showing ability to consistently predict or forecast catalytic events. The key to risk is that it is merely an opinion or a subjective measure based on how far price exceeds intrinsic value of a business and because risk only exists in the future and the future cannot be known, risk cannot be known.
Ben Graham and David Dodd said in “Security Analysis” that “the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions to permit of sound mathematical formula.”
6. The Most Important Thing Is… Recognizing Risk
“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.”
Recognizing risk often starts from understanding the risk as previously explained in Part I. When people are not afraid of risk they will have a tendency to accept that risk without adequately being compensated. When there is a lack of fear or skepticism, investors may purchase investments at high P/E multiples, EBITDA rates, cap rates or narrowing spreads, depending on the asset class.
When risk is viewed as “gone” it may be in itself a dangerous source of risk and a major contributor to bubbles we have experienced in the past. As Howard Marks views it and how I myself have come to view it, “The degree of risk present in the market derives from the behavior of the participants, not from the securities, strategies, and institutions. Regardless of what’s designed into market structures, risk will be low if investors behave prudently.”
Relating to prudency Warren Buffett has a famous quote most will have heard previously: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
Buffett is talking about the risk that participants are willing to undertake at given points in the investment cycle. A healthy and safe financial system should be built on skepticism, risk aversion, worry, distrust, agnostic views and awareness of participants’ attitudes, as it would help reduce the risk participants may be willing to take.
As an influx of demand of increasingly risky assets commences, rates or returns are naturally driven down by price being bid up. Returns are finite and prices paid now may be borrowing from the future as the company “grows into” the multiples it was assigned by eager investors. When viewing a capital markets line with various asset classes from (perceived to be) less risky, to most risky participants may be pushed to higher returns or “reaching for yield” and thus higher risk.
Money Market Funds, five-to-ten year treasuries, corporates, large cap equities, high yield or junk bonds, small cap equities, real estate, buyouts and venture capital are based on interest rates or the risk free rate of return in which an investor can earn. As rates are suppressed investors move up the capital markets line to obtain the same expected rate of return with higher risk thus lowering risk premiums. It is not about predicting the future risks but being aware of what is going on in the present. The market is responsive to investor behavior, actions and attitudes. It is not a market in which we operate but a market in which operates because of us. “The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it,” Marks says.
When lender reticence is on the rise, this may be the time in which the bargains are found. Credit cycles tend to follow economic cycles: reluctance to lend followed by gradual increases of lending followed by competitive lending and relaxed terms, and finally ending with tightening and reluctance to lend. When everyone believes something is risky, the reluctance usually ends up pushing prices to where there is almost no risk, as all positive outlook(s) have been beaten out of the price and there are relatively no or very few willing buyers.
As Buffett famously said, “It’s only when the tide goes out that you find out who’s been swimming naked.” Marks added, “Pollyannas take note: The tide cannot come in forever.”
7. The Most Important Thing Is… Controlling Risk
Loss and risk are two completely different things and as Marks puts it, losses generally only occur when risk collides with negative events, using the parable below for illustration purposes.
“Germs cause illness, but germs themselves are not illness. We might say illness is what results when germs take hold. Homes in California may or may not have construction flaws that would make them vulnerable to collapse during earthquakes. We only find out when earthquakes occur,” Marks says.
Skillful risk control is what separates superior long-lasting investors from the rest. Being protected from once-in-a-generation events may be the limit of how far one can see or adequately control risk due to all kinds of risk associated with investing. One of these is counter-party risk or the risk of not being paid what is rightfully yours due to liquidity constraints in bleak times.
Below are two charts depicting how an investor can add value above and beyond indexing through one of two ways. The first being by additional returns that is easily quantifiable, black or white, and the second being lowered risk, not easily quantifiable or even noticeable in positive times. It is only in negative times that absolute returns and limited risk taking goes noticed and congratulated. By removing yourself completely from risk, positive real rates of return cannot be achieved in the present environment of central bank easing. Normally 3% to 6% in Treasuries may suffice but I am sure no professional investor is in the business for 3% to 6%, or as Will Rogers said, “You’ve got to go out on a limb sometimes because that is where the fruit is.”
Knowing what you don’t know is a very important concept when dealing with risk: The more you are aware of what A) you don’t know and B) you can’t control, the more acceptable the risk levels will be when choosing investments.
(Chart 1 from “The Most Important Thing” by Howard Marks)
(Chart 2 from “The Most Important Thing” by Howard Marks)
8. The Most Important Thing Is… Being Attentive to Cycles
Rule No. 1: Most things will prove to be cyclical.
Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget rule one.
A famous saying most people have probably heard is, “Trees do not grow to the sky,” or, things cannot go on forever. “What comes up must go down,” and many other similar metaphors, are used universally. One of the most dangerous things an investor can do is extrapolate trends into the future while not being attentive of business, investment or credit cycles. Believing good performance will continue and bad events won’t end, it may be difficult to judge exactly where we are in a cycle.
Through experience and education one may be able to draw similarities between past and present behavior and attitudes, thus be attentive to the present. The worst loans are made at the best of times when the economy is in optimistic growth mode, or as Marks says, “In Field of Dreams Kevin Costner was told, ‘If you build it they will come.’ In the Financial world, if you offer cheap money, they will borrow, build and buy – often without discipline, and with very negative consequences.”
Most forecasts and predictions are completely wrong, as proven throughout history by simply searching through old newspaper articles, viewing previous events before hand and viewing the articles after the event. An example of this may be the outlook in 1929, 1999 or 2006 to 2007 (personal favorites) with most participants naively carrying on like “business as usual.” It is understanding the process of the cycles and how they are created and how they are subdued that is important, not forecasting what will happen six months or one year from now.
“Cycles always prevail eventually.” – Howard Marks
9. The Most Important Thing Is… Awareness of the Pendulum
“Investment markets follow a pendulum-like swing: between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced,” Marks says.
Using the analogy of the pendulum with fear and greed at each end, hypothetically the “average” should be the middle or where the pendulum would spend the most time. This unfortunately is not the case, as most of the time the pendulum is moving away from each end (fear or greed) and towards the other opposite. As it resides at one extreme, energy is built up and then released like a spring towards the other extreme, moving quicker towards the other extreme then when it had approached. Those who understand this behavior of the pendulum may benefit enormously. As Marks’ partner, Sheldon Stone, likes to say, “The air goes out of the balloon much faster than it went it.”
The things we don’t know about the pendulum, much like a business cycle are: “how far the pendulum will swing in its arc, what might cause the swing to stop and turn back, when the reversal will occur or how far it will swing in the opposite direction.”
10. The Most Important Thing Is… Combating Negative Influences
“The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing – these factors are near universal. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, wide-spread, and reoccurring,” Marks says.
Marks talks about six emotions that undermine the investment process: greed, fear, dismissal of logic, conformation to the view of the herd rather than resistance, ego and finally, envy.
There are various cognitive biases that also influence and undermine the investment process that investors may be able to exploit, or at the very least, to be aware of the handicap they present. The emotions and biases may be studied, but there is no guarantee investors will thwart them. Oaktree uses the following arsenal of weapons when combating negative influences.
a) A strongly held sense of intrinsic value.
b) Insistence on acting as you should when prices diverge from value.
c) Enough conversance with past cycles – gained at first from reading and talking to veteran investors, and later through experience – to know that market excesses are ultimately punished, not rewarded.
d) A thorough understanding of the insidious effect of psychology on the investing process at market extremes.
e) A promise to remember that when things seem “too good to be true,” they usually are.
f) Willingness to look wrong while the market goes from mis-valued to more mis-valued.
g) Like-minded friends and colleagues from whom to gain support.
Hopefully the wisdom of Oaktree’s Howard Marks will help you immensely, as it has me. His ideas of risk are tightly correlated with those of Nassim Taleb and his three books, “Fooled by Randomness,” “Black Swan” and “AntiFragile.” Keep on alert for both part III and part IIII of the series of articles and in the mean time, I recommend reading the memos below.
11. The Most Important Thing Is… Contrarianism
“To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.” – Sir John Templeton
Howard describes most investors very simply: trend followers. The above average investors must be insightful, skillful, second level thinkers and diverge from the consensus portfolio. Sometimes following the crowd or herd can be profitable, but at other times it my prove to be very unwise and the most unprofitable. At certain inflection points as value investors we must diverge from the crowd, due to fear and skepticism or hope and greed (be greedy when others are fearful and fearful when others are greedy).
Take the lemming as an example. If only this creature had the foresight to stop and leave the warmth of the herd before running over the cliff to its demise for the sake of following. A simple contrarian policy is to buy when they hate them and to sell when they love them, but it may be simpler to say than to do. You have to have the ability to ignore conventional wisdom (as Buffett says, long on conventional short on wisdom) and stick your neck out telling the market it is wrong, as it occasionally is. Contrarians may be strong believers in reversion to the mean and have a strong sense of “intrinsic value” and “a margin of safety” to last through the emotional roller coaster of cycles and swinging of the market pendulum discussed in part II.
Although, as a value investor there is a large difference between “it is over priced” and “it is going down tomorrow.” Or, as the famous Keynes quote says, the market may remain irrational longer than one can remain solvent. But if you believe what everyone else believes, you will do what everyone else is doing, and end up with the same results. Howard says in short, two key primary elements to investing are: “A) seeing some quality that others don’t see or appreciate (and that isn’t reflected in price) and B) having it turn out to be true (or at least accepted by the market).”
By definition to be a contrarian is to “oppose or reject popular opinion; going against current practice.” As Yogi Berra had said famously, “Nobody goes to that restaurant anymore; it’s too crowded.” Over course logically it does not make sense, just like the statement “everyone knows that investment is a bargain”; if they did then it would no longer be a bargain as the price would be bid up.
Sometimes when bargains arise, investors are unsure of what to do or how to interpret certain information and will tell themselves that they will wait until the dust settles. I have heard numerous times the dangers of “catching a falling knife” from friends and colleagues — a t which point, shortly after, the knife has been picked up and taken away by other investors, or as the dust settles there is no longer a bargain to be had.
It is important to weigh what might happen in any given situation against the probability of it happening and act accordingly. The unfortunate truth about being a contrarian at times is that it can be quite lonely, or asHoward Marks said in “Everyone Knows, ” “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.”
12. The Most Important Thing Is… Finding Bargains
Bargains may be found when perception is exceptionally worse than reality. A process where every investor should start is having a list of potential investments, estimates of their intrinsic value, a sense of how large or small the margin of safety is in regard to price and an understanding of the risks involved with each or the correlation among the various asset classes. When you research an investment, if it is fairly valued or richly valued, ask yourself at what price you would buy. As Peter Lynch famously said, “My philosophy has always been, the one who turns over the most rocks, wins the game.”
It is important not to reach for yield or to buy at euphoric parts of the cycle, waiting patiently for bargains to come to you. I think of it much like a garage sale or auction where there are many willing buyers participating, but most participants know very little about the value of the items they are buying and are simply buying because they “want” them. Buying regardless of price is no way to prosper financially in the investment world or in everyday life. We must distinguish the difference between price and value clearly, as bargains usually involve irrational behavior or participants not knowing something about them. Being prepared and working hard are the keys to finding bargains.
Howard says these following places are a great place to start to look or turn over rocks. “A) Unknown areas or not fully understood, B) fundamentally questionable on the surface, C) controversial, unseemly or scary and finally D) deemed inappropriate for respectable portfolios.”
13. The Most Important Thing Is… Patient Opportunism
“The market is not a very accommodating machine; it won’t provide high returns just because you need them.” – Peter Bernstein
As talked about briefly throughout part I, part II and above, the best strategy is often sitting on your hands waiting patiently for bargains to present themselves. Think of the pendulum if you wish as a boomerang that is more accurately caught waiting for it to return to you rather than chasing it down and trying to catch it. Oaktree says one of their mottoes is exactly that, “We don’t look for investments; they find us.” Marks’ tells an intelligent story about the early rise of Japanese culture in business (brought about by William Deming). He talked about the word mujo embedded in the Japanese culture. It means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. We must be prepared and we must be patient.
Insightfully provided are two keys during a crisis. A) You must be insulated from forces that require selling and B) be positioned to be a buyer instead. To be able to do so, an investor must have “a staunch reliance on value, little or no use of leverage, long-term capital and a strong stomach.”
14. The Most Important Thing Is… Knowing What You Don’t Know
“It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what is going on.” – Amos Tversky
There are things in the world that you know you know, there are things you know you don’t know, there are things you don’t know you know, and there are things you don’t know you don’t know. Understanding what you don’t know and focusing on the things you may be able to control or “knowing the knowable” can provide valuable insight, save time and suppress anxiety. Taking an agnostic view combined with skeptical optimism is a healthy way to live in my opinion, as I do. It can lead to confrontations and arguments, or as I call them, “informative debates.”
The most important aspect is second thinking everything, taking an abstract view of how it is conveyed and the incentives behind the proposals, or even more importantly knowing what you cannot know. Big problems may arise when investors forget that there is a difference between probability and actual outcomes and can be caught up in the dogma of others. Staying within your circle of competence, as Warren Buffett says, will lead to better investment results and more importantly, steer you clear of investment mistakes. Are you part of the “I know” school or the “I don’t know” school?
Howard Marks provides a way to identify the “I know school” below.
1) They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks are essential for investment success.
2) They’re confident it can be achieved.
3) They know they can do it.
4) They’re aware lots of other people are trying to do it too, but they figure either a) everyone can be successful at the same time or b) only a few can, but they’re among them.
5) They’re comfortable investing based on their opinions regarding the future.
6) They’re glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.
7) They rarely look back to rigorously asses their records as forecasters.
If you are a part of the “I don’t know,” you will be tired of saying, “I don’t know” to friends, colleagues and family. As Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It is what you know that just ain’t so.”
15. The Most Important Thing Is… Having a Sense of Where We Stand
“We may never know where we’re going, but we’d better have a good idea of where we stand.”
Markets cycles have a profound influence on the performance of investors and are both inevitable and unpredictable. As investors the questions we most often ask, and the answers we most often receive, are obvious, and more often then not, they are not the correct ones. We must be both proactive in controlling risk, (thus minimizing mistakes) and reactive in approaching opportunities, bargains and investor sentiment or attitudes towards the present situation. Knowing where we stand much relates to part II, being aware of the pendulum as well as being attentive to cycles.
Howard Marks talks about “taking the market’s temperature” through various questions like, “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 P/E ratios high or low in context of history, and are yield spreads tight or generous? Is too much money chasing too few deals? Has the number of deals increased and the ease of them being done less prudent?”
Understanding where we are should be attentively pursued to a certain extent, the same extent in which you would look at the weather outside when deciding what to wear on any given day. Of course the weather outside is more of an objective matter, where as understanding of where we are in a market cycle may be more objective. This business is the art in which investors must practice and gain from experience, like many other areas of the investment process.
If you have not already done so, I would recommend reading the first three parts of the series of articles found here: Part I, Part II and Part III. I would also recommend reading the memos attached to each article and the book, “The Most Important Thing” by Howard Marks, as he is very insightful and provokes metacognition with an investing/risk focus.
16. The Most Important Thing Is… Appreciating the Role of Luck
Luck and chance are two things investors should cherish dearly when dealt a great hand. As we all know there is a difference between what may happen or has happened and the probability of it happening. A great example of this is when Warren Buffett went to speak to a manager of GEICO on a Saturday afternoon. It was closed and as chance had it, the one man in the building let him in and talked to him extensively about GEICO after Buffett had found out Ben Graham sat on the board of directors. This investment turned out to be the most successful of both Warren’s and Ben’s career. Or as Nassim Taleb talks about in “Alternative Histories,” that could have just of easily occurred as what actually did occur.
Nassim Taleb had said, “Clearly my way of judging matters is probabilistic in nature; it relies on the notion of what could have probably happened… If we have heard of [history’s great generals and investors], it is simply because they took considerable risks, along with thousands of others, and happened to win. They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day – but do did thousands of others who live in the musty footnotes of history:”
Essentially, history’s spoils go to the winners in a take-all fashion, but it could have just as easily gone the other way.
Most often the luck is not re-creatable because it was just that, luck. Skill and luck are very different contrasts as illustrated in another one of Taleb’s passages. “$10 million earned through Russian roulette does not have the same value as $10 million earned through diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one’s dependence on randomness is greater than the other. To your accountant, though they would be identical… Yet, deep down, I cannot help but consider them as qualitatively different.”
We should analyze the probability of success when luck or randomness is involved and confer the likelihood of it happening again. As in poker, the quality of an investment decision is not governed by the outcome (monetary gain) but by the process in which the participant went through to reach his thesis.
17. The Most Important Thing Is… Investing Defensively
“There are old investors and there are bold investors, but there are no old bold investors.”
Investing defensively means exactly that, playing defense, minimizing error or risk, as appose to maximizing gains or reward. Howard uses a great metaphor in regards to a professional tennis players and the game they play relative to investors.
“So much is within the control of the professional tennis players that they should really go for winners. And they’d better, since if they serve up easy balls, their opponents will hit winners of their own and take points. In contrast, investments results are only partly within the investors’ control, and investors can make good money – and outlast their opponents—without trying tough shots. The bottom line is that even highly skilled investors can be guilty of miss-hits, and the overaggressive shot can easily lose them the match. Thus, defense—significant emphasis on keeping things from going wrong—is an important part of every investors game.”
Consistency is key in the realm of defense, routinely doing what is right while occasionally making new progress through flashes of offense, relative to investing, flashes of brilliant ideas. I use a simple (and probably over used) metaphor, instead of being focused on slugging percentage alone, you should be focused on the batting average and walked percentage in relation to home runs earned. It is the consistent singles, with an occasional “homer” that win the game. Everything in the capital markets is a two edged sword, as you attempt to take higher returns you are also willingly (and maybe unknowingly) taking more risk. There is no right or wrong, but trade-offs that must be made between risk and return, and the volatility that an investor may be able to stomach. Ensuring the ability to survive over the long-term is more important than short-term gains and a portfolio should be built to withstand a scenario of 2008-2009 or worse. Howard mentions in his book how brief most exceptional investment careers are, how competition is eroded by the sands of time and bad choices, and finally how many brilliant people struck out swinging for the fences (see Long-term Capital Management case studies). It is an unfortunate truth but directly related to Aesop’s parable of the tortoise and the hair. “Slow and steady wins the race.” Although the parable also brings focus to complacency, narcissism, and ego, I believe the root of the lesson to be centered on patience and persistence, much like long-term investment success. Investing scared is not something to be ashamed of but something to be emulated by all rational and intelligent investors. Knowing what you don’t know and can’t control are two very powerful things. As mentioned everything is a two edged sword and I would like to conclude this portion with a quote from what Howard calls his favorite fortune cookie.
“The cautious seldom err or write great poetry.”
18. The Most Important Thing Is… Avoiding Pitfalls
“An investor needs do very few things right as long as he avoids mistakes.” – Warren Buffett
Most investor pitfalls lay within A) incorrect or lack of information B) emotions/psychology and C) excessive fees and taxes. An investor who does not construct a portfolio with enough risk is forgoing returns, although no one that I have heard of has gone broke from that. Investing is an analytical process, weighing both tangibles and intangibles that may either be examined though both quantitative and qualitative measures.
Many of the errors based around emotions and psychology have been talked about in previous parts of the article, so I will not go in to depth about fear and greed. An investor must be flexible, allowing for unpredictable events to occur, and take outliers with a grain of salt. Living in a probability-driven world can drive a man mad due to the unpredictable factors of human nature, among many other variables. Acknowledging that some probabilities can’t be quantified and learning to accept and capitalize on unlikely events is one of the greatest tools a rational investor has. No imagination or a lack of it will also prove to be a hindrance to an investor seeking above-average returns, or as Sam Walton likes to call it: “Swimming up stream” will get you where others aren’t.
Howard Marks also states how investors are naïve or unaware to the correlation between asset classes held within a portfolio. Diversification proves to be unneeded or more likely unwanted if returns are reduced to mitigate loss, but in turn very little, if any losses are mitigated.
Marks also states three points in which investors are harmed by the forces of the market:
– By succumbing to them.
– By participating unknowingly in markets that have been distorted by others’ succumbing.
– By failing to take advantage when those distortions are present.
Some of the keys to success are the ability to observe, learn and adapt to changing tides while having a strong sense of confidence in ones research and/or self. Being patient and sitting on your hands is sometimes the best approach to finding investments, allowing the ideas to come to you. When an investor is doing research, he must calculate the numbers for himself, collecting information from primary resources, not secondary opinions. Using conservative estimates to form “ranges of outcomes” will also provide protection from mistakes in the analytical process.
|Common Mistakes of Investors||Fear||Greed|
|Not buying||Buying too much|
|Not buying enough||Buying too aggressively|
|Not making on more bid||Making one bid too many|
|Not using enough leverage||Using too much leverage|
|Not taking enough risk||Taking too much risk|
19. The Most Important Thing Is… Adding Value
When adding value one of the most accurate and efficient measurements regarding the risk-adjusted return may be the sharpe ratio. Calculating the excess return produced by alpha (the measurement of management performance) versus beta (the correlation to market volatility) may prove insightful to an investor seeking a talented fund manager. There is no way to know the full risk of a portfolio until hindsight is available and reflections may be made after the storm has passed. Managers or investors may simply take on more volatility in search of higher returns. Howard uses another simple yet brilliant two-by-two matrix to depict two very different investors [size=11.0pt;line-height:115%; font-family:”Calibri”,”sans-serif”;mso-ascii-theme-font:minor-latin;mso-fareast-font-family: Calibri;mso-fareast-theme-font:minor-latin;mso-hansi-theme-font:minor-latin; mso-bidi-font-family:”Times New Roman”;mso-bidi-theme-font:minor-bidi; mso-ansi-language:EN-US;mso-fareast-language:EN-US;mso-bidi-language:AR-SA”>—
|Aggressive Investor||Defensive Investor|
|Without Skill||Gains a lot when the market goes up, and loses a lot when the market goes down.||Doesn’t lose much when the market goes down, but doesn’t gain much when the market goes up.|
|With Skill||Gains a lot when the market goes up, but doesn’t lose to the same degree when the market goes down.||Doesn’t lose much when the market goes down, but captures a fair bit of the gain when the market goes up.|
Comparing various benchmarks (apples to apples) over a given period of time (say five or 10 years) would most likely provide enough insight into a particular fund manager, if of course that is what you are looking for. Otherwise it may be used to evaluate oneself and ultimately make the decision to A) stay your course, B) find a new captain, or C) buy a passive index fund and hold on forever.
20. The Most Important Thing Is… Pulling It All Together
Pulling it all together refers to using the other 18 points (excluding adding value and putting it all together from the 20) in an efficient manner. I would advise re-reading the first three parts at this point followed by “The Most Important Thing” by Marks and finally Oaktree memos found throughout the article and on the Oaktree website.
Further Reading from Howard Marks: