By Ken Faulkenberry of Arbor Investment Planner
Howard Marks, author of “The Most Important Thing: Uncommon Sense for the Thoughtful Investor”, is the Chairman of the Oaktree Capital Management. Marks was one of the original founders and is famous for his “memos to Oaktree clients” which he uses liberally throughout the book to add value.
Even though value investing is about numbers, this book has no numbers. This book is about psychology and thinking differently about value portfolio management. I highly recommend this book to every investor. It’s easy to read and easy to understand. It can change the way you think about investing. These are my summaries of the chapters of the book.
Summary of The Most Important Thing by Howard Marks
“No rule always works. The environment isn’t controllable, the circumstances rarely repeat exactly. Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable.”
This most important thing is second level thinking. You have to think beyond the obvious (first level thinking). The first level thinker sees favorable circumstances and decides to buy. The second level thinker sees that the investment is over hyped and too expensive to provide a margin of safety.
The first level thinker sees unfavorable circumstances and decides to sell. The second level thinker sees that investors have panicked and driven the price to bargain levels and buys.
“Inefficient markets do not necessarily give their participants generous returns. Rather, it’s my view that they provide the raw material — mispricings —that can allow some people to win and others to lose on the basis of differential skill.”
The most important thing is understanding market efficiency and its limitations. While it is true that many markets are fairly efficient most of the time, they are not always efficient. Investors allow greed, fear, and other emotions to defeat their objectivity. This leads the way to significant mistakes.
Investors who choose to believe the market can’t be beat leave the inefficiencies for those willing to be second level thinkers. Understanding market inefficiencies is important so that you recognize opportunities that can be exploited for profit.
“Investors with no knowledge of (or concern for) profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time.”
The most important thing is value. Marks talks about the difference between growth and value. Growth is a bet on the future, an uncertain future. Therefore you may be paying for something that does not materialize.
Value is more consistent. Paying less than something is really worth today is less of a risk than guessing what will happen in the future. The best value is when you can buy growth at a value price, but that may not always be available.
“No asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.”
The most important thing is the relationship between price and value. Investors psychology can cause a stock price to be mis-priced. In the short run, investing is more like a popularity contest.
The most dangerous time to buy an investment is at the peak of its popularity. At that time, all the positive data and assumptions are reflected in the price. Everyone that is going to buy has already bought.
The optimal time to buy an investment is when no one else wants it. At that point, all the negative data and assumptions are reflected in the price. Everyone that is going to sell has already sold.
Buying at a price below the real worth of an investment is the most reliable approach to making an investment profit.
“The possibility of permanent loss is the risk I worry about.”
The most important thing is understanding risk. There are several misconceptions about risk: Riskier assets don’t necessarily provide higher rates of return or they wouldn’t be riskier. Risk doesn’t come from weak fundamentals because almost any investment, bought at the right price, can be a profitable investment. Risk does not come from volatility; risk comes from how an investor reacts to volatility.
Risk can be greatly reduced by 1) making an accurate assessment of the real value of an investment and 2) making sound decisions based on the relationship of the price to the value. Investments that are overpriced should be avoided or sold. Investments that are underpriced are candidates for purchase.
“The degree of risk present in a market derives from the behavior of the participants, not the securities, strategies, and institutions.”
The most important thing is recognizing risk. Risk is actually highest when everyone believes risk is low. This is because investors bid up the price of the asset to the point it really is risky. At a high price favorable outcomes have low expected returns and unfavorable outcomes can result in large losses.
Risk is lowest when everyone believes that risk is high. This is because investors have reduced the price to the point it’s no longer risky. At a low price favorable outcomes have high expected returns and unfavorable outcomes result in smaller losses.
Investors should recognize risk comes with price; not the quality of an investment. “High quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them.”
Related Reading: Perceived Risk vs. Real Risk
“The road to long-term investment success runs through risk control more than aggressiveness. Skillful risk control is the mark of the superior investor.”
The most important thing is controlling risk. Over an entire investment career, the amount and size of investment losses will most likely have more to do with returns than the magnitude of winners.
Controlling risk is not risk avoidance. The stock market will have more good years than bad years. The fact that the benefits of controlling risk only come in the form of losses that don’t happen, make it hard to measure and easy to succumb to ignoring. It is just at that time that risk meets adversity and punishes you. Controlling risk is a permanent task.
“Cycles will never stop occurring. If there were such a thing as a completely efficient market, and people really made decisions in a calculating and unemotional manner, perhaps cycles would be banished. But that’ll never be the case.”
The most important thing is being attentive to cycles. Cycles have a way of being self-correcting. Reversals don’t necessarily need outside events. They reverse on their own. Success creates the seeds of failure, and failure creates the seeds of success.
Periodically investors decide that a trend will never end. When times are good they conclude the trend will continue upward forever. When times are bad they talk about vicious cycles and “self-feeding” developments that will not end.
Don’t assume trends will continue forever. Instead be aware of possible major turning points.
“When investors in general are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-adverse, prices can offer more return than risk.”
The most important thing is awareness of the pendulum. Markets
fluctuate between euphoria and desperation. The “happy medium” is the average. But in reality the market spends very little time at the average. The pendulum swings back and forth, creating opportunities for the astute investor who is aware of the swings (and extremes) in investor sentiment.
“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”
The most important thing is combating negative influences. Greed, fear, the tendency to dismiss logic, the tendency to conform, envy, and ego are psychological forces that can be negative influences.
These forces are universal and become very powerful as a group. This is especially true at market extremes and results in mistakes that can damage personal returns for a lifetime.
There are several guidelines that increase your odds. Stick to the concepts of intrinsic value and margin of safety. Use the principles in this book (The Most Important Thing) to stay cognizant of the investment environment.
“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
The most important thing is contrarianism. Most investors are trend followers. The best investors do just the opposite. When there is a broad consensus among investors it means that most have acted and the current price reflects those actions.
If the majority of investors have bought because conditions are perceived as favorable the price is high. This leaves lots of risk but little potential for reward. If the majority of investors have sold because conditions are perceived to be unfavorable the price is low. This reduces the risk and provides a large potential for reward.
The necessary condition for the existence of bargains is that perception has to be considerably worse than reality”.
The most important thing is finding bargains. Investment bargains have nothing to do with quality. A high quality investment can be a good or bad buy. It depends on what you pay for it.
A failure to differentiate between good assets and good buys will get most investors into trouble. What it comes down to is that for an investment to be a bargain, perception has to be worse than reality. In other words, if the perceived risk is greater than the real risk the price will be a bargain.
“You want to take risk when others are fleeing from it, not when they’re competing with you to do so.”
The most important thing is patient opportunism. Sometimes the best action is no action. Waiting for lower prices is often the prudent strategy.
Marks provides a tip: Select from a list of things sellers are motivated to sell instead of having a fixation on what you want to own. He points out that in investing you never have to swing (baseball analogy). There are no penalties for patience.
Maintain a balanced perception of market conditions. Buy and sell at price points that are favorable to you. That is usually the opposite of the crowd consensus.
“No one likes having to invest for the future under the assumption that the future is largely unknowable. On the other hand, if it is, we’d better face up to it and find other ways to cope than through forecasts”.
The most important thing is knowing what you don’t know. Forecasts about the economy and future twists and turns in stock markets are dangerous and probably worthless in the long run.
Pay attention to valuations, balance sheets, and income statements and less on economic forecasts and markets. Have a general idea of where valuations are in terms of cycles and pendulums, but don’t try to forecast the unknowable.
“We may never know where we’re going, but we’d better have a good idea where we are. That is, even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.”
The most important thing is having a sense for where we stand. We need to be aware of the current environment. Is the outlook for the economy positive or negative? Are the capital markets loose or tight? Are risk spreads narrow or wide? Are investors eager to buy, or eager to sell? Are asset prices high or low?
Use the information we have and know today to make investment decisions based on probability, not forecasts. We should be cautious when others have aggressively driven prices higher. We should be more aggressive when others have panicked and driven prices lower.
“Randomness contributes to (or wrecks) investment records to a degree that few people appreciate fully. As a result, the dangers that lurk in thus-far-successful strategies often are underrated.”
The most important thing is appreciating the role of luck. You cannot judge the propriety of an investment decision by the outcome. Some bad decisions produce good outcomes. Some good decisions produce bad outcomes.
Some investors build their portfolio to maximize profits based on their forecasts. If by random chance their forecast is correct, they look like a genius. However, since we know the future is unknowable, that investor may have just been lucky.
A sound investor will invest defensively based on a broad range of probabilities. High priority will be placed on respect for risk and randomness of events; including attempting to avoid pitfalls that could devastate a portfolio.
“Investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.”
Most investment managers fail because they are too aggressive; not because they are too careful. Trying to make above average gains through taking on more risk is a fools game for most investors.
In reality, a balanced but somewhat defensive game, based on keeping individual losses to a minimum and avoiding very poor years, makes more sense.
The best risk control is insisting on a margin for error. Having a healthy respect for risk, paying a low price, and acknowledging what they don’t know makes the best investment managers.
“At the important turning points, when the future stops being the past, extrapolation fails and large amounts of money are either lost or not made.”
The most important thing is avoiding pitfalls. Rationales that dominate cycles usually coincide with the belief that “it’s different this time”. They are pitfalls that cause maximum harm to the maximum number of herd followers. These rationales should be recognized and avoided by the second-level thinkers.
In the short term, psychological and technical factors can override or subjugate fundamentals. By definition most people join the trend and help create the bubble or crash. These are times it’s especially important to be contrarian and think defensively.
Leverage multiplies results but does not add value. Leverage might make sense when purchasing assets at bargain prices with high expected returns. On the other hand, using leverage to buy assets with low expected returns and high risk is a recipe for exaggerated losses.
“Asymmetry – better performance on the upside than on the downside relative to what your style alone would produce — should be every investor’s goal.”
The most important thing is adding value. Marks advocates being the defensive investor who strives to lose less than the market in downturns, but capture a fair amount of the gains in a rising market.
Beta is a measurement of how much a portfolio moves compared to the market. An aggressive investor (high beta) without skill will gain a lot when the market goes up and lose a lot when the market falls. The defensive investor (low beta) without skill won’t lose much when the market falls, but won’t gain much when the market rises. This kind of investor adds no value.
Alpha is a measurement of personal investment skill. This is a measurement of portfolio performance that is unconnected to the movement of the market. Positive alpha would mean that over a down and up cycle the investor does better than the market. A negative alpha would mean that over a down and up cycle the investor underperforms the market.
“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.”
The most important thing is pulling it all together. You have to be confident in your assessment of value. You have to have the courage to stay disciplined when the price varies from your valuation assessment. You must be strong enough to overcome the powerful psychological influences that will attempt to get you to join the consensus.
The risk that matters is the risk of permanently losing your principal. Risk control is the heart of defensive investing. Put a heavy emphasis on not doing the wrong thing.
The key to investment success is getting the price and value relationship right. There is no way to know what the future holds, so insisting on a margin for error is the best approach to adding value. The larger the margin for error the higher the probability of success.
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