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Howard Marks

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What Is the Most Important Thing in Investing?

Discovering the key factors for successful investing according to Howard Marks.

“The Most Important Thing” by Howard Marks takes a deep dive into his investment philosophy. It first started as a collection of memos which have been collected and expanded into one single book. The book is meant to inspire and rethink one's own investment strategy rather than to provide specific steps to investing.

The art of investment has one characteristic that is not generally appreciated. A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom.

Benjamin Graham

Using index funds, everyone can achieve average investment performance. Therefore the simple definition of successful investing is to be better than the market and other investors. Marks uses the book to define key characteristics which make successful investors better than the crowd. This post takes a deeper look at those characteristics.

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Value Investing

Marks describes himself as a value investor who buys assets below intrinsic value and then sells at a higher price. Value investors try to value companies based on hard assets and cash flows. Intangible assets without a clearly defined value, like talent, long-term growth potential and others are given less weight. However they are still valuable as they can translate into future earnings and cash flow and therefore shouldn't be omitted completely.

According to Marks there is no clear distinction between value and growth. Both require the investor to deal with the future of an asset. The main difference between the two is that growth investors emphasizes the future more than value investors do who are more focused on the present. Marks prefers value investing though as value investing can be more consistent in generating returns than growth investing.

The price of an asset is not only determined by its value but also by psychology and technical factors, at least in the short-term. Those two factors can cause an assets to be priced completely decoupled from its value in the near future. Successful investors need the ability to correctly detect those instances when the price diverges significant from intrinsic value and at the same time have to be strong enough to resist psychological impacts and following the crowd.

However buying underpriced assets does not guarantee that they will immediately go up as being correct about the value of an asset is not the same as being proven correct right away. The stock might become even more underpriced or stay underpriced for a long time. Hence patience is important and it makes sense to average-down rather than to sell the investment. Investors also have to stay strong in order to average-down rather than selling the assets when prices fall.

According to Marks its very rare to stumble upon assets that are so bad that they can’t be a good investment at a cheap enough price while its almost certain that the best assets can be bad investments at an expensive price.

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Second-Level Thinking

Everyone can read books, take courses or find a mentor in finance in order to be an investor. But only a few will master investing and gain superior insights, intuition, sense of value and an awareness of the psychology of the market. However according to Marks these attributes are necessary to be an above-average investor who is more right than others.

First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.

Howard Marks

The underlying ability to achieve superior investing performance is second-level thinking. Being a second-level thinker means to incorporate much more and better information into investment decisions and to consider more than one potential outcome.

Compared to second-level thinkers, first-level thinkers tend to have one fixed opinion about the future and often come to the same conclusions as other first-level thinkers. But by doing the same thing as everyone else investors expose themselves to exaggerated fluctuations in the market prices which should be avoided, especially when the market goes down.

For your performance to diverge from the norm, your expectations - and thus your portfolio - have to diverge from the norm, and you have to be more right than the consensus.

Howard Marks

Second-level thinking is highly coupled to the idea of contrarianism. However investors should not just do the opposite of what the crowd does. It is important that they also know why the crowd is wrong. This requires investors to see some qualities in an investment which haven’t been acknowledged yet and for those to turn out true.

Skepticism is another important factor. It’s not enough to just have a look at the financial statements. They also have to be checked and questioned in order to financial engineering or extraordinary exceptions.

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Market Cycles

Some of the best gains or biggest losses happen as a result of market cycles. There's progress which turns into deterioration and then back to progress. Those cycles appear both as a result of outside factors like world events, technical developments or environmental changes as well as over- or under-reactions of market participants.

One example for market cycles is the expansion and contraction of companies. They expand operations, facilities or employees when the future looks good and then have to undo those expansions once the future becomes less rosy. Similarly access to capital is mostly unrestricted when the future looks good but then becomes too restrictive once things turn bad.

Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever, and investments that are outperforming will outperform forever, and vice versa. Instead, it‘s the opposite that’s more likely to be true.

Howard Marks

Similar to the market cycles investment markets follow a pendulum-like swing between overpriced and underpriced as a result of positive and negative market sentiment. Psychological factors like greed, fear, optimism and pessimism or faith in the developments play a big role. According to Marks the greed/fear cycle comes from changing attitudes towards risks. During times of greed investors are more comfortable with risk and similarly during times of fear they don‘t take enough of it.

When combined with improper risk aversion these factors can lead to bubbles and crashes. The good news for value investors is though that stocks are cheapest when everything is looking grim. Buying during those times can create the biggest profits for investors.

Investors should always try to figure out where they are in the current market cycle. While it’s impossible to predict this future knowing the current state can provide benefits in managing the portfolio and preparing for upcoming changes. For example when others display greed and recklessness it’s better to be cautious while it’s better to be aggressive in times of fear.

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Market Mistakes

Marks believes that the efficient market hypothesis holds some truth. New information and prices are reflecting the consensus view of that information. However where he deviates from the hypothesis is that he does not believe that the consensus view is necessarily correct.

Similarly he believes that investors can't consistently beat the market. While investors can temporarily beat it, over the long run they will regress to the mean market performance. This is why investors like Warren Buffett attract as much attention. They proof that investors who consistently beat the market are in fact exceptional.

However Marks believes into the idea that markets can be inefficient. This means that it is prone to mistakes which can be taken advantage of by investors. Reasons for those mistakes can be emotions, like greed, fear, envy, capitulation or by limits that investors impose onto themselves. By taking advantage of them investors will be able to outperform the market.

The biggest enemy to investors is greed. Nobody is immune to it and it is strong enough to overcome common sense, risk aversion, prudence, caution, logic or past learnings. It can force investors to follow the crowd and make mistakes. The counterpart to greed is fear which, according to Marks, is equivalent to panic in the investment world. Similar to greed it leads investors to dismiss logic and past learnings. It keeps them from recognizing recurrent patterns and profit from them.

Similar to greed envy causes mistakes through the comparison with other investors. For many investors it’s hard to see other investors making a lot of money while they themselves have mediocre returns. This again causes them to chase the quick buck rather than the long-term gain.

Another mistake investors can make is to conform to the thinking of the herd even if their view is clearly wrong. It causes investors to drop their caution, independence and risk aversion to get rich quick. Finally there is capitulation which kicks in once investors can’t keep their conviction anymore once pressure from the herd becomes too strong. This often happens at the end of market cycles.

All those factors have in common that they are subject to the pressure of the crowd and the constant competition in the market. As a result it is inevitable to avoid market mistakes when giving way to those pressures. However it is key to resist those forces and follow one‘s own convictions to avoid those mistakes.

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Risk Management

A majority of the book deals with risk and how to manage it. Risk is an important part in investing and it should be equally considered together with the potential return before investing. According to the capital market theory risk equals volatility. However Marks argues that most investors are not scared of volatile investments but of the total loss of capital or very low returns. Therefore risk is not quantifiable and depends on each persons individual risk tolerance.

Investing consist of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.

Howard Marks

Riskier investments are those where the probability distribution of returns is wider and therefore the outcome is less certain. They have to offer better prospects in order to attract capital. There is however no guarantee that riskier investments will yield higher returns.

Risk is not only present in an asset itself but also in the market. Even if an asset was bought at a low enough price there is still risk from psychological influences or once-in-a-lifetime events. For example exciting stories or already successful companies can motivate investors to invest more and therefore decoupling the price of an asset from its value causing high risk.

The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed. Certainly the fact that an investment worked out doesn’t mean it wasn’t risky, and vice versa. With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities.

Howard Marks

As risk is only becoming visible once it occurred it is impossible to tell whether an investment is risky or not. As a result it is important for successful investing to not only have a fixed expectation but to have a sense of other possible outcomes and their likelihood. This is contrasted by the expectation of the crowd that trends continue as also discussed in the book “The Acquirer's Multiple” by Tobias Carlisle.

The risk in investing is primarily dominated by too-high prices and resulting excessive optimism and lacking skepticism. Risk can be increased by low prospective returns on safe investments which cause investors to move into riskier investments. By bidding up prices the returns on investments get lower and risk rises. And as the prices rise investors demand less risk premiums which leads to even higher risk. At the same time investments that are believed to be risky are avoided to the point that the price is so low that it's not risky at all.

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not a risky at all.

Howard Marks

Controlling risk in a portfolio is an important aspect of successful investing. However if this is being done successfully it is only visible in losses that didn’t occur. This is why many people look up to investors with high returns during bull markets and big losses in bear markets rather than to investors with low losses in bear markets and moderate returns in bull markets. However Marks argues that it should be the other way around.

One often ignored aspect in constructing a portfolio is asset correlation. While risk is often evaluated for a single assets investors miss out on evaluating how certain events will effect the entire portfolio. For example one asset might react to a change of another or two assets might react similarly. According to Marks understanding this correlation is a key factor to avoid heavy losses.

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Finding Bargains

To successfully manage a portfolio investors have to buy undervalued investments and get rid of investments which have appreciated or are not meeting expectations. To find suitable investments investors first have to identify potential investments and their intrinsic value and then compare them by how the prices relate to their intrinsic value and how risky they are. The investments with the best ratio of potential return to risk should then be added to the portfolio. As the goal is to buy good purchases, not good assets, its important what is being paid for the asset.

Inefficiencies - mispricings, misperceptions, mistakes that other people make - provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance.

Howard Marks

Undervalued assets are usually the ones which are out of favor. They tend to display some objective defect or weakness. Investing into them has the advantage that the downside is already calculated into the price. In the worst case the price won‘t go down much more while in the best case demand can only go up.

Those might be hard to understand and therefore left aside. It might also be an asset which is being ignored to the extend where its only mentioned negatively in the media, for example due to controversial aspects of the business. Finally a falling price might scare of first-level thinkers which don’t see beneath the surface. All these aspects might should be thoroughly checked to ensure they’re better than how they’re perceived by the crowd.

One of the great things about investing is that the only real penalty is for making losing investments. There’s no penalty for omitting losing investments, of course, just rewards. And even for missing a few the penalty is bearable.

Howard Marks

There might be times in which undervalued assets are rare and hard to find. In those times its best to display patient opportunism and wait for bargains. According to Marks its better to buy something others want to sell rather than to have a predefined wish list as those investments probably won’t be sold at a bargain price. It’s impossible to create investment opportunities if they don’t exist.

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Investing Skill

There is two kinds of investors: Those who think they know the future and those who think they don’t. The ones who think they know the future will make more directional and concentrated bets using leverage while those who don’t while put more focus on hedging, diversification and using little to no leverage.

There are two kinds of people who lose money: those who know nothing and those who know everything.

Howard Marks

In other words those investors who think they know the future are offensive investors while those who don't think they know the future are defensive investors. Offensive investors try to achieve high returns through aggressive tactics and elevated risk. Offensive investors also aim for high returns but through consistently avoiding bad investments rather than to have occasional exceptional ones. They do this by weeding out losers through in-depth due diligence as well as avoiding losses during port years and crashes.

Active investors have to make changes to their portfolio in order to perform better than the market. This can be done for example by making the portfolio more aggressive or defensive than the index. However to truly stand out investors need alpha which describes the skill of an investor. Investors with alpha can be identified easily as their added value is asymmetrical: In good times their gain is higher than the market while in bad times their loss is much lower.

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