The Most Important Things in Investing

I previously wrote about second-level thinking, a key concept in Howard Marks’ book The Most Important Thing. As the co-founder of Oaktree Capital Management, the largest investor in distressed securities in the world, Marks regularly posts valuable succinct memos that I subscribe to and encourage everyone to do so.

With extracts from his memos and a lifetime of experience and research, this book is a summary of the most essential elements of successful investing. I gained so many good lessons and reminders, so here are my takeaways.

1. Focus on Inefficient Markets
2. Intrinsic Value is the Basis
3. Know the Relationship between Price and Value — Find Good Buys, not Good Assets
4. Recognize and Resist Psychological Errors
5. Understand Risk
6. Pay Attention to Cycles — Extremes Will Reverse
7. Be Contrarian Based on Reason to Find Bargains
8. Patient Opportunism — Marks’ Investing Strategy
9. We Don’t Know Where We Are Going, but We Should Know Where We Are Today
10. Invest Defensively i.e. Avoid Losers and Exposure to Excess Risk
11. Avoid Pitfalls
12. Marks’ Notes on Lessons from a Crisis
13. Asymmetry of Performance Shows True Investing Skills

Focus on Inefficient Markets

Second-level thinkers know that to achieve superior results, they must have an edge in information or analysis or both — they depend on inefficiency. Be on the alert for misperceptions — “who doesn’t know that?”

Marks admits in today’s world, there is limited inefficiency in the market to take advantage of due to information availability. BUT he believes it is not so universal that we should give up on superior performance. We should focus efforts on relatively inefficient markets where hard work and skills pay off the best.

My takeaway: inefficient markets can include small cap stocks under the radar of institutions (Powermatic Data), emerging markets (I consider chinese equities, as it’s less understood by western investors)

Intrinsic Value is the Basis

Value vs. Growth investing: the choice isn’t really between value and growth, but between value today and value tomorrow.

Marks described that the upside for being right about growth is more dramatic, while that for value is more consistent. And he chooses to be more consistent.

My takeaway: this book was written back when Marks was more of a traditional value investor. Regardless, intrinsic value is the core of any investing strategy. Growth adds an expectation of the future which is less certain and more volatile. To me, it boils down to having accurate and informed expectations. Hence staying in your circle of competence is important for that expectation to have a high probability of being realized.

Know the Relationship between Price and Value — Find Good Buys, not Good Assets

Assuming the estimate of value is right, the most dependable way to profit is to buy below value when perception understates reality → a key element in limiting risk.

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

Besides value, the price of a security is affected by:

• Technicals: non-fundamental factors that affect supply and demand e.g. forced selling during a market crash, inflows of cash to mutual funds that require portfolio managers to buy. Buying from a forced seller is the BEST.
• Psychology: investing is a popularity contest, the most dangerous thing is to buy something at the peak of its popularity, where all favorable facts are already factored into the price and no new buyers are left to emerge.

Recognize and Resist Psychological Errors

Many people can reach similar cognitive conclusions from analysis, but what they do with the conclusions varies because psychology influences differently. The biggest investing errors come not from analytical factors, but from psychological ones.

7 key psychological errors: Greed, Fear, Suspension of Disbelief, Conformism, Envy, Ego, Capitulation

To avoid losing money in bubbles, the key lies in refusing to join when greed and human error cause positives to be wildly overrated and negatives to be ignored.

To increase the odds of defeating psychology:

• Hold a strong sense of intrinsic value
• Act as you should when price diverges from value
• Know the past cycles that excesses are punished, not rewarded
• When things seem too good to be true, they usually are
• Be willing to look wrong while market goes from misvalued to more misvalued
• Have like-minded friends to gain support from

Understand Risk

Risk — the probability of permanent loss — is invisible before and even after the fact.

Our decisions tend to look at past patterns — once in a while, something very different happens and we underestimate the consequences. Why’s that the case? When we take more risk, return may increase but the probability distribution of returns (or losses) becomes wider too.

People view risk-taking as a way to make money (high risk high returns) but higher return is never guaranteed, or else risky investments won’t be risky in the first place.

Recognizing risk: investment risk resides most where it is least perceived and vice versa.

Controlling risk: bear risk when we are well paid to do so, especially by taking risks toward which others are averse in the extreme.

Diversification: not just holding different things, but having securities that will reliably respond differently to a given development in the environment

Pay Attention to Cycles — Extremes Will Reverse

Most things prove to be cyclical, and some of the greatest opportunities for gain and loss come when other people forget the first rule.

Cycles always prevail, because cycles are self-correcting. Success carries within itself the seeds of failure, and failure the seeds of success.

Like the market, psychology of the investing herd moves in a pendulum-like pattern from optimism to pessimism. Risk aversion — an appropriate amount is essential in a rational market — is sometimes in short supply or in excess. This fluctuation causes the swing of this pendulum, building up energy that contributes to the swing back in the other direction.

We won’t know how or when the pendulum swings, but we can be sure that extremes will reverse. Those who believe the pendulum moves in a direction forever will lose huge sums.

What the wise man does in the beginning, the fool does in the end.

Be Contrarian Based on Reason to Find Bargains

If everyone likes it, it’s because it has been doing well, price has risen to reflect it, and the area is mined too thoroughly for any bargain to remain.

Contrarianism itself can be mistaken for herd behaviour — don’t be contrarian for the sake of it. For contrarianism to be profitable, it must be based on reason and analysis. Because you know why the crowd is wrong. Only then will you be able to hold firmly to your views when there are losses initially.

My takeaway: I think the concept of bargains is a bit archaic, rooted in traditional value investing but not so relevant today. Marks also admit that bargains are rare in an efficient market. That said, when perception is considerably worse than reality e.g. a stock fall >20% after a mild guidance revision, we should take note.

Patient Opportunism — Marks’ Investing Strategy

Wait for bargains, be discerning, relatively inactive and react opportunistically.

Marks believes we will do better if we wait for investments to come to us rather than go chasing after them. There are better buys if we select from things sellers are motivated to sell, rather than start with a fixed notion of what we want to own.

M y takeaway: I like this philosophy, but it’s one of the hardest things to do: to do nothing and to act against the crowd. Hence to strike a balance, I believe it’s a good idea to DCA a small amount every month while keeping a war chest to pounce at opportunities when they arise.

We Don’t Know Where We Are Going, but We Should Know Where We Are Today

It’s impossible to know the future… but while we don’t know where we are going, we ought to know where we are right now, given that nothing is as dependable as cycles.

Marks’ advice: stay alert if the market has reached an extreme and adjust our behaviour.

Just like the golfer’s choice of club depends on the wind, our decision of outerwear varies with weather, our investment actions should be affected by the current investing reality, not by the uncertain future expectations.

So how do we know where we are today? Marks provided a Poor Man’s Guide to Market Assessment or a list of useful questions to ask ourselves.

My takeaway: this is one of the wisest pieces of advice I’ve learned from the book. Accordingly, I consider the current climate to be in balance, a neutral ground between the extremes. Rates are low, asset prices high but it’s a mixed picture for economic outlook and recent performance.

Invest Defensively i.e. Avoid Losers and Exposure to Excess Risk

Marks brings up an analogy from Charles Ellis about tennis.

Professional tennis is a “winner’s game” where the match goes to the player who is able to hit the most winners. But the tennis most of us play is a “loser’s game” with the match going to the player who hits the fewest losers. In amateur tennis, points aren’t won, they’re lost.

His views on market efficiency and high cost of trading led him to conclude that the pursuit of winners in the mainstream markets is unlikely to pay off for the investor. Instead we should try to avoid hitting losers.

The choice between offense and defense investing is based on how much the investor has within his control. And for us, there is a lot that isn’t. Thus defense — keeping things from going wrong — is an important part of every great investor’s game.

Oaktree portfolios are set up to outperform in bad times where outperformance is essential, and stay average in good times. This way, they have above-average returns over full cycles with below-average volatility.

2 key elements in defensive investing:

• Avoid losers by doing extensive due diligence, demanding a low price and margin for error, and ignoring rosy forecasts
• Avoid poor years and exposure to meltdown via diversification and limiting risky or offense approaches (e.g. leverage or concentration)

We could argue that we want to play a winner’s game, but are we overestimating our skills? The more challenging or lucrative the waters you fish in, the more likely they attract skilled fishermen. Playing offense in technically challenging fields mustn’t be attempted without requisite competence. It’s crucial to know yourself and play your own game (another great piece from a writer I respect, Morgan Housel).

My takeaway: this reminds me of Buffett’s classic quote “Rule no. 1 never lose money. Rule no. 2 never forget Rule no. 1”. I do think given how widely available information and knowledge is, it is possible to increase our competence. That said, most retail investors act like they are in a “winner’s game” when truthfully their skills do not match up. Know thyself.

Avoid Pitfalls, Including the Urge to Act

An investor needs do very few things right as long as he avoids big mistakes. -Warren Buffett

Errors come from 2 main sources:

1. Analytical: We collect too little or incorrect information, apply wrong analysis, omit errors — hence having a proper framework and going for good courses are important. There is also the “failure of imagination” — not conceiving the full range of outcomes or anticipating co-movement within a portfolio (correlation).
2. Psychological: Indulge in the 7 emotions (above) and hence take too much or little risk, failing to recognize market cycles and move in opposite direction.

While there are times when errors are of commission (buying) or of omission (not buying), there are times when investor psychology is at equilibrium and there’s no glaring error. When there’s nothing particularly clever to do, the pitfall lies in insisting on being clever.

Marks’ Notes on Lessons from a Crisis

• Too much capital availability makes money flow to the wrong places
• When capital flows to where it shouldn’t, bad things happen
• 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 — the best defense against loss is thorough, insightful analysis and insistence for margin for error
• Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem
• Leverage magnifies outcomes but doesn’t add value — it makes great sense to use leverage to increase investment in quality assets at bargain prices, but it is dangerous to do so in fully priced or overpriced assets. There is no sense in using leverage to turn inadequate returns into adequate returns
• Excesses correct
• Leading up to a crisis, investors could: take note of carefree behaviour of others, prepare psychologically for a downturn, sell riskier assets, reduce leverage, raise cash

My takeaway: as Mark Twain said, history doesn’t repeat itself, but it often rhythms. These serve as good reminders for myself in my investing journey.

Asymmetry of Performance Shows True Investing Skills

Investors who lack skill simply earn the returns of the market dictated by their style e.g. aggressive investors move a lot in both directions.

Investors who truly add value produce decent performance in environments not suited for their style e.g. aggressive investor avoids giving back too much gains during down market → this asymmetry is the expression of real skill.

Concluding Thoughts

Seriously, this was such a thoughtful and comprehensive book full of wisdom, I consider it to be a mandatory learning material for investors. Some concepts may be a bit traditional or outdated, but the underlying philosophies stay relevant.

Have a healthy respect for risk, be aware that we won’t know what the future holds, understand the best we can do is view the future as a probability distribution, insist on defensive investing and avoiding pitfalls.

I would come back to this book again and again. Hope this has been as enlightening for you as it has been for me!

Originally published at https://financialavocado.com on September 5, 2021.