I spent some time this week catching up on a backlog of videos I’ve wanted to watch. Two stood out.
The first is a Q&A with Howard Marks. The second is a conversation with Ben Hunt. The two conversations fit well together.
The hour-long Q&A session with Marks kicks off with how margin safety fits into distressed debt investing. Of course, it’s no different than any intelligent strategy. As Marks explains it, “If you can make those judgments on the basis of conservative assumptions and still end up with good room for profit, then that’s a source for margin of error.”
The purpose of Ben Graham’s margin of safety is to give yourself room to make mistakes and not lose much (or still come out ahead). Most people should understand that.
Unfortunately, conservative is not a natural tendency at the peak of a market cycle when optimism takes hold. Margin of safety is tossed out the window by then for an excessively optimistic view of the future. But those who cling to a margin of safety end up better protected once the euphoria turns to doubt.
It’s that same cycle that drives investment strategies to go in and out of favor. Marks talks about how to run an organization when its “business” goes out of favor. His answer is the same for the question, “how do run a strategy that goes in and out of favor?” You must be long-term oriented and embrace delayed gratification. Emotional control plays a huge part in that. Marks explains:
But if you think about the market cycle…what’s happening? And we’re in one of these periods. The economic news is good. Everything on MSNBC is favorable. The newspapers only report the good news. Most stories can be given a positive spin. The companies are performing and they’re generally exceeding expectations. The stock prices are rising. The rising stock prices are making people feel good. People are turning more optimistic. Their fears are abating. Their eagerness is rising. And they’re buying. And people tend to buy more when prices go higher. And then, of course, the reverse is true on the other side. The news is bad. People get depressed. They’ve lost money. They feel terrible and they start to sell.
So people tend to buy a lot [near the top] and sell a lot [near the bottom]. Now, unless I’m mistaken, they got it wrong. You’re supposed to buy [at the bottom] and sell [at the top]… Buy low, sell high. It’s a very easy dictum. So why do they do the opposite? … I think we can lump the explanation under the heading of emotion… You make the really big money in this world by unhooking from the market when it gets up here and everybody’s happy and nobody can think of anything that could go wrong. And everybody thinks that trees are gonna grow to the sky. So you sell… And then the market collapses… Nobody can think anything will ever go right again. And stock prices are devoid of any optimism at all. And that’s a great time to buy.
But to be that, you have to be a contrarian and you have to be able to diverge from the crowd. Now, if you think about it, everybody receives the same inputs. We read the same newspaper, the economic news is the same for all us, the corporate news is the same for all of us, the TV says the same thing to all of us. Some of us see the news and the prices as a buy signal, just when most people see the news and prices as a sell signal, and vice versa. And you want to be in the minority.
Back in the early ’70s somebody gave me a great gift and told me about the three stages of a bull market. The first stage: when only a few unusually perceptive people believe to understand that there could be some improvement. The second stage: when most people accept that improvement is actually taking place. And the third stage: when everybody and his brother believes that things can only get better forever.
You make a lot of money if you buy in the first stage. You lose a lot of money if you buy in the last stage. You buy the same things, but what matters is when do you buy them and at what price. The prices are set low because everybody else is pessimistic. You should be optimistic. The market is set high and dangerous when everybody else is optimistic. You should be pessimistic. But it takes, obviously, emotional control to be able to do that.
The role narrative plays throughout a cycle, how people interact with it, whether they recognize it, are influenced by it, or embrace it completely, fits into what Marks is talking about. Emotional control is important but so is understanding the why behind the narrative in order to be a good contrarian.
Because it’s not enough to just go against the crowd. You can spend your entire investing lifetime betting opposite the crowd and failing every step of the way. You also need to be right. Which is hard to do without the ability to deconstruct the narratives. And that’s where the next video comes in.
The conversation with Ben Hunt winds a bit before they dive into the role of narratives, behavioral nudges, and the power of words in (and outside of) markets. Hunt’s been tackling the topic at Epsilon Theory (worth checking out).
The media does narratives well. It usually involves taking a highly complex thing and simplifying it into an easy to understand story.
For example, the media does it by attaching an explanation to the daily direction of the market. It’s as if a highly complex machine, made up of random fluctuations, can be simplified so easily. But that’s what happens and some people eat it up.
And there are a number of these narratives playing out at once. Lately, there’s the yield curve narrative, the inflation narrative, the long bull market narrative, the buybacks are evil narrative…sometimes there’s too many to keep track. Some with wither and die quickly. Some will refuse to die. Some might have a hidden agenda. Some might actually be true. And they pop up and morph throughout the cycle.
The key question is to always ask “Why?” What’s the reason for the narrative? Why is that story being pushed now? Of course, that requires stepping back and recognizing it for what it is. That’s the hard part but it’s not impossible.
And social media plays a role in accelerating the spread of some narratives. It’s Keynes’s beauty contest on steroids. It’s crowd dynamics at a heightened, accelerated rate. It’s an ongoing experiment, it’s live, and we’re all the guinea pigs.
That’s what makes it interesting and a little freaky. The conversation is worth watching.
Lastly, an important point was made at the beginning of their chat that’s worth repeating.
Humility is a necessity. Chance, luck, or misfortune play a bigger role in markets than most people believe and humility is key to accepting it.
Investing is not just about recognizing patterns. It’s knowing that chance makes patterns imperfect. There are probabilities and unknown elements involved in every decision. You can be right and unlucky or wrong and lucky (or right and lucky or wrong and unlucky). Humility is needed to deal with the possibilities of being right and wrong, lucky and unlucky properly.
- The Disproportional Power of Anecdotes – Farnam Street
- Charles Wagner’s 100-Year-Old Warning About Social Media – C. Newport
- Why Doesn’t The Stock Market Care About the News? – A Wealth of Common Sense
- The First Totally Honest Stock Market Story – J. Zweig
- What Inning is the Market in Today? – D. Schawel
- Doomsayers and Market Prophets – Mathematical Investor
- Vanguard Investors Share Advice for Weathering Market Volatility – Vanguard
- The Terrifying Hidden Reality of Ridiculously Complicated Algorithms – TLS
- The Wired Guide to Quantum Computing – Wired
- The Man Who Walked Backwards – TexasMonthly
- The Oral History of Gold’s Gym – Deadspin