The Most Important Thing | Uncommon Sense For The Thoughtful Investing by Howard Marks

June 17, 2022

Brief Summary

Howard Marks, the chairman and cofounder of Oaktree Capital Management, is renowned for his insightful assessments of market opportunity and risk. After four decades spent ascending to the top of the investment management profession, he is today sought out by the world's leading value investors, and his client memos brim with insightful commentary and a time-tested, fundamental philosophy. Marks's wisdom need to be sought out attentively for seasoned and as well as amateur investors. His ability to understand what drives the market while articulating those lessons to others is worth paying attention to. Learning from a practitioner who also understands academia is a worthwhile pursuit. This book in many ways is redundant because it spells out the foundational lessons of investing, specifically active investment management. However, Howard Mark has his own way of spinning those lessons and sharing them with public. I enjoy his writing very much. The main takeaway of this book is markets are psychologically driven, and if, and when an investor understands that, an investor can benefit tremendously. Experience, second-level thinking, fundamentals of human psychology, understanding risk and avoiding herd mentality are hugely beneficial in independent thinking when it comes to investing. This book has gone into my re-read section.

Big Ideas

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.
Your view of value has to be based on a solid factual and analytical foundation, and it has to be held firmly. Only then will you know when to buy and sell. 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. Of course, for your efforts in these regards to be profitable, your estimate of value has to be on target.
The relationship between price and value holds the ultimate key to investment success. Buying below value is the most dependable route to profit. Paying above value rarely works out as well.
What causes an asset to sell below its value? Outstanding buying opportunities exist primarily because perception understates reality. Whereas high quality can be readily apparent, it takes keen insight to detect cheapness. For this reason, investors often mistake objective merit for investment opportunity. The superior investor never forgets that the goal is to find good buys, not good assets.
In addition to giving rise to profit potential, 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.
The relationship between price and value is influenced by psychology and technicals, forces that can dominate fundamentals in the short run. Extreme swings in price due to those two factors provide opportunities for big profits or big mistakes. To have it be the former rather than the latter, you must stick with the concept of value and cope with psychology and technicals.
Economies and markets cycle up and down. Whichever direction they're going at the moment, most people come to believe that they'll go that way forever. This thinking is a source of great danger since it poisons the markets, sends valuations to extremes, and ignites bubbles and panics that most investors find hard to resist.
Likewise, the psychology of the investing herd moves in a regular, pendulum like pattern from optimism to pessimism; from credulousness to skepticism; from fear of missing opportunity to fear of losing money, and thus from eagerness to buy to urgency to sell. The swing of the pendulum causes the herd to buy at high prices and sell at low prices. Thus, being part of the herd is a formula for disaster, whereas contrarianism at the extremes will help to avert losses and lead eventually to success.
In particular, risk aversion- an appropriate amount of which is the essential ingredient in a rational market is sometimes in short supply and sometimes excessive. The fluctuation of investor psychology in this regard plays a very important part in the creation of market bubbles and crashes.
The power of psychological influences must never be underestimated. Greed, fear, suspension of disbelief, conformism, envy, ego and capitulation are all part of human nature, and their ability to compel action is profound, especially when they're at extremes and shared by the herd. They'll influence others, and the thoughtful investor will feel them as well. None of us should expect to be immune and insulated from them. Although we will feel them, we must not succumb; rather, we must recognize them for what they are and stand against them. Reason must overcome emotion.
Most trends—both bullish and bearish—eventually become overdone, profiting those who recognize them early but penalizing the last to join. That's the reasoning behind my number one investment adage: "What the Wise man does in the beginning, the fool does in the end." The ability to resist excesses is rare, but it's an important attribute of the most successful investors.
It's impossible to know when an overheated market will turn down, or when a downturn will cease and appreciation will lake its place. But 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.
Not even contrarianism, however, will produce profits all the time. The great opportunities to buy and sell are associated with valuation extremes, and by definition they don't occur every day. Were bound to also buy and sell at less compelling points in the cycle, since few of us can be content to act only once every few years. We must recognize when the odds are less in our favor and tread more carefully.
Buying based on strong value, low price relative to value, and depressed general psychology is likely to provide the best results. Even then, however, things can go against us for a long time before turning as we think they should. Underpriced is far from synonymous with going up soon. Thus the importance of my second key adage: "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.
In addition to being able to quantify value and pursue it when it's priced right, successful investors must have a sound approach to the subject of risk. They have to go well beyond the academics' singular definition of risk as volatility and understand that the risk that matters most is the risk of permanent loss. 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. They have to have a sense for the loss potential that's present in each investment and be willing to bear it only when the reward is more than adequate.
Most investors are simplistic, preoccupied with the chance for return. Some gain further insight and learn that it's as important to understand risk as it is return. But it's the rare investor who achieves the sophistication required to appreciate correlation, a key element in controlling the riskiness of an overall portfolio. Because of differences in correlation, individual investments of the same absolute riskiness can be combined in different ways to form portfolios with widely varying total risk levels. Most investors think diversification consists of holding many different things; few understand that diversification is effective only if portfolio holdings can be counted on to respond differently to a given development in the environment.
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. Thus, a low incidence and severity of loss is part of most outstanding investment records. Oaktree's motto, "If we avoid the losers, the winners will take care of themselves," has served well over the years. A diversified portfolio of investments, each of which is unlikely to produce significant loss, is a good start toward investment success.
Risk control lies at the core of 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 ad- verse circumstances is incompatible with maximizing returns in good times, investors must decide what balance to strike between the two. The defensive investor chooses to emphasize the former.
Margin for error is a critical element in defensive investing. Whereas most investments will be successful if the future unfolds as hoped, it takes margin for error to render outcomes tolerable when the future doesn't oblige. 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. Emphasizing these elements can limit your gains in good times, but it will also maximize your chances of coming through intact when things don't go well. My third favorite adage is "Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average. * Margin for error gives you staying power and gets you through the low spots.
Risk control and margin for error should be present in your portfolio at all times. But you must remember that they're "hidden assets. " Most years in the markets are good years, but it's only in the bad years—when the tide goes out—that the value of defense becomes evident. Thus, in the good years, defensive investors have to be content with the knowledge that their gains, although perhaps less than maximal, were achieved with risk protection in place...even though it turned out not to be needed.
One of the essential requirements for investment success- and thus part of most great investors' psychological equipment- is the realization that we don't know what lies ahead in terms of the macro future. 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 know- able": industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don't.
Many more investors assume they have knowledge of the future direction of economies and markets- and act that way—than actually do. They take aggressive actions predicated on knowing what's coming, and that rarely produces the desired results. Investing on the basis of strongly held but incorrect forecasts is a source of significant potential loss. Many investors, amateurs and professionals alike- assume the world runs on orderly processes that can be mastered and predicted. They ignore the randomness of things and the probability distribution that underlies future developments. Thus, they opt to base their actions on the one scenario they predict will unfold. This works sometimes—winning kudos for the investor—but not consistently enough to produce long term success. 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.
An important part of getting it right consists of avoiding the pitfalls that are frequently presented by economic fluctuations, companies' travails, the markets' manic swings, and other investors' gullibility. There's no surefire way to accomplish this, but awareness of these potential dangers certainly represents the best starting point for an effort to avoid being victimized by them.
Neither defensive investors who limit their losses in a decline nor aggressive investors with substantial gains in a rising market have proved they possess skill. 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. Can the aggressive investor keep from giving back gains when the market turns down? Will the defensive investor participate substantially when the market rises? This kind of asymmetry is the expression of real skill. Does an investor have more winners than losers? Are the gains on the winners bigger than the losses on the losers? Are the good years more beneficial than the bad years are painful? And are the long- term results better than the investor's style alone would suggest? These things are the mark of the superior investor. Without them, returns may be the result of little more than market movement and beta.
Only investors with unusual insight can regularly divine the probability distribution that governs future events and sense when the potential re. turns compensate for the risks that lurk in the distribution's negative left-hand tail. This simple description of the requirements for successful investing-based on understanding the range of possible gains and the risk of untoward developments—captures the elements that should receive your attention. I commend the task to you. It'll take you on a challenging, exciting and thought-provoking journey.

Quotes

I like to say, “Experience is what you got when you didn’t get what you wanted.
There are old investors, and there are bold investors, but there are no old bold investors.
“Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time...or become far more so.
Investment success doesn’t come from “buying good things,” but rather from “buying things well.”
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.
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.
Here’s the key to understanding risk: it’s largely a matter of opinion.
Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge.
Every once in a while, an up-or-down-leg goes on for a long time and/or to a great extreme and people start to say "this time it's different." They cite the changes in geopolitics, institutions, technology or behavior that have rendered the "old rules" obsolete. They make investment decisions that extrapolate the recent trend. And then it turns out that the old rules still apply and the cycle resumes. In the end, trees don't grow to the sky, and few things go to zero.
There’s only one way to describe most investors: trend followers. Superior investors are the exact opposite. Superior investing, as I hope I’ve convinced you by now, requires second-level thinking—a way of thinking that’s different from that of others, more complex and more insightful.
Selling for more than your asset’s worth. Everyone hopes a buyer will come along who’s willing to overpay for what they have for sale. But certainly the hoped-for arrival of this sucker can’t be counted on. Unlike having an underpriced asset move to its fair value, expecting appreciation on the part of a fairly priced or overpriced asset requires irrationality on the part of buyers that absolutely cannot be considered dependable.
The most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price and no new buyers are left to emerge.
Once in a while, however, the future turns out to be very different from the past. It’s at these times that accurate forecasts would be of great value. It’s also at these times that forecasts are least likely to be correct. Some forecasters may turn out to be correct at these pivotal moments, suggesting that it’s possible to correctly.
People should like something less when its price rises, but in investing they often like it more.
The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.
Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.
Everything you needed to know in the years leading up to the crash could be discerned through awareness of what was going on in the present.
If everyone likes it, it's probably because it has been doing well. Most people seem to think that outstanding performance to dates presages outstanding future performance. Actually, it's more likely that outstanding future performance to date has borrowed from the future and thus presages subpar performance from her on out.
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.
An accurate estimate of intrinsic value is the essential foundation for steady, unemotional and potentially profitable investing.
Most people strive to adjust their portfolios based on what they think lies ahead. At the same time, however, most people would admit forward visibility just isn't that great. That's why I make the case for responding to the current realities and their implications, as opposed to expecting the future to be made clear.
Charlie Munger gave me a great quotation on this subject, from Demosthenes: “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” The belief that some fundamental limiter is no longer valid—and thus historic notions of fair value no longer matter—is invariably at the core of every bubble and consequent crash. In fiction, willing suspension of disbelief adds to our enjoyment.
Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.
Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on. Look around the next time there’s a crisis; you’ll probably find a lender.
When risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.
The correctness of a decision can’t be judged from the outcome. Nevertheless, that's how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa.
If your behavior is conventional, you’re likely to get conventional results—either good or bad. Only if your behavior is unconventional is your performance likely to be unconventional, and only if your judgments are superior is your performance likely to be above average.
It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.
If you've settled on the value approach to investing and come up with an intrinsic value for a security or asset, the next important thing is to hold it firmly. That's because in the world of investing, being correct about something isn't at all synonymous with being proved correct right away.
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, widespread and recurring.
This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something's risky. But high quality assets can be risky, and low quality assets can be safe. It's just a matter of the price paid for them... Elevated popular opinion, then, isn't just the source of low return potential, but also of high risk.
In good years, defensive investors have to be content with the knowledge that their gains, although perhaps less than maximal, were achieved with risk protection in place, even though it turned out not to be needed.
Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.
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’s going on.
Good builder is able to avoid construction flaws, while a poor builder incorporates construction flaws. When there are no earthquakes, you can’t tell the difference.
The market can remain irrational longer than you can remain solvent.