Book Review: The Most Important Thing

Fantastic book on investing. Howard Marks is one of the clearest thinkers I’ve read when it comes to sound investment advice. The concept of ‘second-level thinking’ is spot on. His exploration of the relationship between risk and return brings clarity to a financial world that is often obfuscated by headlines and hype. Ultimately good investing is about holding non-conformist views that are correct, and having the emotional and psychological strength to stand by your convictions. Much easier said than done. Perhaps the best thing to take away from the book is the concept of knowing what type of return environment you’re in – it doesn’t work to chase high returns in a low return environment, you’ll end up taking on much more risk than you can stomach and likely won’t be well compensated for that risk.

Defensive investing sounds very erudite, but I can simplify it: Invest scared!

One other thing I took away from this book was the idea of using a basic market assessment to figure out whether now is a time to be cautious or more aggressive. You can take a look at the sheet I created, and copy it for yourself if you’re interested!

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Read, and prosper!


On managing risk:

In particular, you’ll find 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.

On first and second level thinking:

First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”

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?

Would-be investors can take courses in finance and accounting, read widely and, if they are fortunate, receive mentoring from someone with a deep understanding of the investment process. But only a few of them will achieve the superior insight, intuition, sense of value and awareness of psychology that are required for consistently above-average results. Doing so requires second-level thinking.

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?”

On holding non-consensus views:

The upshot is simple: to achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate. That’s not easy. The attractiveness of buying something for less than it’s worth makes eminent sense. So how is one to find bargains in efficient markets? You must bring exceptional analytical ability, insight or foresight. But because it’s exceptional, few people have it.

If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or non-consensus, view.

On ‘efficient markets’:

In the end, I’ve come to an interesting resolution: 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? Think of it this way: 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? Something else to keep in mind: just because efficiencies exist today doesn’t mean they’ll remain forever.

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.

On value vs. growth investing:

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. Value is my approach. In my book, consistency trumps drama.

On intrinsic value:

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.

At Oaktree we say, “Well bought is half sold.” By this we mean we don’t spend a lot of time thinking about what price we’re going to be able to sell a holding for, or when, or to whom, or through what mechanism. If you’ve bought it cheap, eventually those questions will answer themselves.

On psychology:

And that brings me to the second factor that exerts such a powerful influence on price: psychology. It’s impossible to overstate how important this is. In fact, it’s so vital that several later chapters are devoted to discussing investor psychology and how to deal with its manifestations. Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship—and the outlook for it—lies largely in insight into other investors’ minds. Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.

The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.

On understanding risk:

Riskier investments are those for which the outcome is less certain. That is, the probability distribution of returns is wider. When priced fairly, riskier investments should entail: higher expected returns, the possibility of lower returns, and in some cases the possibility of losses.

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. It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money.

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.

I’ve recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity.

On probabilities and outcomes:

The possibility of a variety of outcomes means we mustn’t think of the future in terms of a single result but rather as a range of possibilities. The best we can do is fashion a probability distribution that summarizes the possibilities and describes their relative likelihood. We must think about the full range, not just the ones that are most likely to materialize. Some of the greatest losses arise when investors ignore the improbable possibilities.

On risk and return:

Recognizing risk often starts with understanding when investors are paying it too little heed, being too optimistic and paying too much for a given asset as a result. High risk, in other words, comes primarily with high prices. 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.

Whereas the theorist thinks return and risk are two separate things, albeit correlated, the 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.

But only when investors are sufficiently risk-averse will markets offer adequate risk premiums. When worry is in short supply, risky borrowers and questionable schemes will have easy access to capital, and the financial system will become precarious. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety.

Homes in California may or may not have construction flaws that would make them collapse during earthquakes. We find out only when earthquakes occur. Likewise, loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.

That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.

On cycles:

In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and “sure things” can fail. However, there are two concepts we can hold to with confidence: Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

This belief that cyclicality has been ended exemplifies a way of thinking based on the dangerous premise that “this time it’s different.” These four words should strike fear—and perhaps suggest an opportunity for profit—for anyone who understands the past and knows it repeats. Thus, it’s essential that you be able to recognize this form of error when it arises.

When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.

On greed and fear:

There’s nothing wrong with trying to make money. Indeed, the desire for gain is one of the most important elements in the workings of the market and the overall economy. The danger comes when it moves on further to greed, which Merriam-Webster’s defines as an “inordinate or all-consuming and usually reprehensible acquisitiveness especially for wealth or gain.”

The counterpart of greed is fear—the second psychological factor we must consider. In the investment world the term doesn’t mean logical, sensible risk aversion. Rather, fear—like greed—connotes excess. Fear, then, is more like panic. Fear is overdone concern that prevents investors from taking constructive action when they should.

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. This is especially true at the market extremes. The result is mistakes—frequent, widespread, recurring, expensive mistakes.

On randomness and luck:

Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not. Thus, when considering whether an investment record is likely to be repeated, it is essential to think about the role of randomness in the manager’s results, and whether the performance resulted from skill or simply being lucky. $10 million earned through Russian roulette does not have the same value as $10 million earned through the 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.

The easy way to see this is that in boom times, the highest returns often go to those who take the most risk. That doesn’t say anything about their being the best investors. Warren Buffett’s appendix to the fourth revised edition of The Intelligent Investor describes a contest in which each of the 225 million Americans starts with $1 and flips a coin once a day. The people who get it right on day one collect a dollar from those who were wrong and go on to flip again on day two, and so forth. Ten days later, 220,000 people have called it right ten times in a row and won $1,000. “They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.” After another ten days, we’re down to 215 survivors who’ve been right 20 times in a row and have each won $1 million. They write books titled like How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning and sell tickets to seminars. Sound familiar?

Seth Klarman: This is why it is all-important to look not at investors’ track records but at what they are doing to achieve those records. Does it make sense? Does it appear replicable? Why haven’t competitive forces priced away any apparent market inefficiencies that enabled this investment success?

On defensive investing:

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.

But 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 winner just keeps the ball in play until the loser hits it into the net or off the court. In other words, in amateur tennis, points aren’t won; they’re lost. I recognized in Ramo’s loss-avoidance strategy the version of tennis I try to play. Charley Ellis took Ramo’s idea a step further, applying it to investments. His views on market efficiency and the high cost of trading led him to conclude that 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. I found this view of investing absolutely compelling. 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.

What is offense in investing, and what is defense? Offense is easy to define. It’s the adoption of aggressive tactics and elevated risk in the pursuit of above-average gains. But what’s defense? Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.

Defensive investing sounds very erudite, but I can simplify it: Invest scared!

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