Buy the Book: Howard Marks’s The Most Important Thing lays the groundwork for being a successful investor. He details the investment principles needed to tackle the complexity of markets and investing.
The Notes
- Notes are based on the Illuminated edition.
- “Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times.”
- In investing, no rule works all the time. Markets are fluid systems, influenced by many variables, including the players involved in it. Change is constant. Surprises are inevitable. Unexpected things do happen.
- The best investment approach should be built on common sense and flexibility.
- “Beating the market matters, but limiting risk matters just as much. Ultimately, investors have to ask themselves whether they are interested in relative or absolute returns. Losing 45 percent while the market drops 50 percent qualifies as market outperformance, but what a pyrrhic victory this would be for most of us.” — Seth Klarman
- Second Level Thinking:
- To earn above-average returns, you not only must think differently and behave differently than everyone else, but you must be right more often than the consensus.
- “First-level thinking says, “I think the company’s earnings will fall; sell.”
- “Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.””
- First-level thinkers rely on headlines and consensus opinions to make investment decisions.
- Second-level thinkers weigh the possible outcomes, compare it against the consensus view, understand the consequences of being wrong, and the probability of being right.
- First-level thinking is simplistic and binary.
- Second-level thinking is complex and probabilistic.
- Second-level thinkers often ask: “Who doesn’t know that?”
- “The idea is that agreeing with the broad consensus, while a very comfortable place for most people to be, is not generally where above-average profits are found.” — Joel Greenblatt
- Market Efficiency: markets are quick to incorporate new information into asset prices. However, it does not mean assets are priced accurately.
- More “efficient” assets tend to be: widely known, broadly followed, socially acceptable, and the information on it is widely available and comprehensible.
- More “inefficient” assets tend to be: little known or followed, taboo or controversial, and the information on it is limited and/or difficult to understand.
- Inefficiency is necessary to outperform the market, but won’t guarantee it.
- Assets prices are a product of consensus view. A contrarian view, and being right, is needed to recognize mispricing in markets. That, of course, is not easy given the same information and behavioral hurdles — including straying from the consensus — as everyone else.
- “Psychological influences are a dominating factor governing investor behavior. They matter as much as—and at times more than—underlying value in determining securities prices.” — Seth Klarman
- Chance — good or bad luck — plays a bigger role in short term investment outcomes. Skill plays a bigger role in the cumulative outcome over many, many decades.
- “Human beings are not clinical computing machines. Rather, most people are driven by greed, fear, envy, and other emotions that render objectivity impossible and open the door for significant mistakes.”
- “Many of the best bargains at any point in time are found among the things other investors can’t or won’t do.”
- “Let others believe markets can never be beat. Abstention on the part of those who won’t venture in creates opportunities for those who will.”
- “Warren Buffett says that the best investment course would teach just two things well: How to value an investment and how to think about market price movements.” — Joel Greenblatt
- Intelligent investing is based on estimates of intrinsic value.
- Value investing looks for assets that can be valued based on fundamental factors like earnings or cash flows, which can be bought at a considerable discount to that value. Said another way, value investing looks to buy stocks with a current value significantly higher than its current price.
- The bigger the discount between price and value, the wider the margin of safety. A margin of safety brings added protection from unexpected events, being wrong, etc.
- “It’s hard to consistently do the right thing as an investor. But it’s impossible to consistently do the right thing at the right time. The most we value investors can hope for is to be right about an asset’s value and buy when it’s available for less.”
- Investing is a waiting game. In other words, waiting is a big part of any strategy, be it value, growth, etc. Perfectly timed stock purchases don’t happen without a lot of luck. Investors have no control over how quickly the market corrects a misalignment between value and price. Waiting is required.
- “Unless you buy at the exact bottom tick (which is next to impossible), you will be down at some point after you make every investment.” — Joel Greenblatt
- Waiting inevitably means investors are bound to look wrong often. But if the judgment of intrinsic value is correct, then it’s only temporary. That means being comfortable with losses. Fear of looking wrong, being uncomfortable with losses, is what gets investors into trouble.
- A proper valuation, made with confidence, is the best defense against emotional decisions.
- “There are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.”
- “Investment success doesn’t come from “buying good things,” but rather from “buying things well.””
- “It has been demonstrated time and time again that 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.”
- “There’s no such thing as a good or bad idea regardless of price!”
- A large margin of safety makes selling at the right price less important.
- Market prices are largely affected by psychology and technicals in the short term. Investors’ psychology can produce wild price swings in the short run. Understanding psychology is key to being able to take advantage of it. Controlling your own emotion is also key.
- Great opportunities arise when buying from forced sellers. That means don’t become a forced seller. Build a strategy that avoids forced selling at any price.
- “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.”
- A “good” stock can produce losses if you overpay. A “bad” stock can produce gains when bought cheap. An “overpriced” stock can go higher. An “underpriced” stock can go lower. But eventually, valuation does matter.
- Roads to Investment Profits:
- Increase Intrinsic Value: It’s difficult to predict. Often any potential increase is already priced in. To profit, the actual increase in value must exceed the market’s — the consensus — expectations.
- Apply Leverage: A “good” investment doesn’t become a “great” investment with leverage. Leverage only magnifies gains and losses. It increases the risk of ruin.
- Sell an Asset for More Than Its Worth: It requires a greater fool to come along and overpay for your asset.
- Buy an Asset for Less Than Its Worth: One of the most reliable ways to profit…so long as you’re willing to wait. Even so, it’s not always guaranteed to work.
- Risk
- “Risk means more things can happen than will happen.” — Elroy Dimson
- Risk results from an unknowable future.
- Avoiding or minimizing risk is a good thing.
- Investment decisions should always consider the risk involved and potential return. Then determine if the return justifies the risk.
- Riskier investments have a wider range of outcomes and more uncertainty around where the outcome falls. In other words, uncertainty means riskier investments can have high returns, low returns, or even a loss. And the probability distribution may be impossible to predict.
- Risk = the possibility of permanent loss.
- Other Types of Risk to Watch for:
- Falling Short of Your Goals: investing is personal. It’s usually done with specific goals in mind like retirement, college education, etc. Not meeting those goals poses a risk.
- Benchmark Risk: is an unwillingness to underperform a popular benchmark index, like the S&P 500, in the short term.
- Career Risk: when a fund manager’s investment decisions are based more on keeping their job than the outcome of their funds.
- Unconventionality: the risk of being different. Investing differently than the market often leads to returns that deviate from the market — not always in a good way. Being unconventional can get people fired or lead to market-beating returns.
- Illiquidity: liquidity is the ability to turn assets into cash without sacrificing on price. The risk is not being able to do that when cash is needed most.
- Risk is a function of price and value.
- Risk of loss can be caused by strong or weak fundamentals depending on the price paid.
- Risk of loss is possible under a strong or weak economic environment.
- “The most dangerous investment conditions generally stem from psychology that’s too positive. For this reason, fundamentals don’t have to deteriorate in order for losses to occur; a downgrading of investor opinion will suffice. High prices often collapse of their own weight.”
- Risk is often an educated guess. It’s also difficult to measure in hindsight. Every investment has a range of outcomes. It’s impossible to measure risk knowing the outcome that did occur, without also knowing all the alternative outcomes.
- “…the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation.” — Security Analysis, Graham and Dodd
- “Some of the greatest losses arise when investors ignore the improbable possibilities.”
- “There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” — Bruce Newberg
- Randomness and luck play a role in individual investment outcomes.
- Most investors make decisions with the expectation that the future will mirror the past and underestimate change.
- Worst-case projections are often based on what we know through history and fail to consider that something worse than what’s already happened, can happen.
- “Unusual and unlikely things can happen, and outcomes can occur in runs (and go to extremes) that are hard to predict. Underestimating uncertainty and its consequences is a big contributor to investor difficulty.”
- “The received wisdom is that risk increases in the recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions.” — Andrew Crockett
- Risk is uncertainty in the possibility that loss occurs out of all the possible outcomes.
- High risk and low returns due to high prices are one and the same.
- Risk tolerance, for the average investor, tends to move opposite of stock prices. As prices rise too high, investors become less risk-averse (more risk-tolerant) when they should be more risk-averse.
- Many market bubbles were blown under the belief that something has no risk. Risk exists in every investment. The belief in no risk stems from widespread investor behavior that’s extremely optimistic and risk-averse. It’s a danger to watch out for. Risk is highest when the belief risk doesn’t exist is widespread.
- “Risk cannot be eliminated; it just gets transferred and spread.”
- Things to watch out for when risk is highest is excessive optimism, nonexistent skepticism, easy credit, strong capital inflows, low returns on “safe” investments, recent high returns on typically “unsafe” investments, and a belief that those returns will stay high going forward.
- In most cases, people are overconfident in their ability to see risk and avoid it.
- The “Perversity of Risk” = “When investors feel risk is high, their actions serve to reduce risk. But when investors believe risk is low, they create dangerous conditions. The market is dynamic rather than static, and it behaves in ways that are counterintuitive.”
- Risk is often highest when the consensus believes it is lowest and vice versa. When the consensus believes an investment is risky and refuses to own it, their unwillingness likely reduces its price to a point where risk is lowest. The opposite is also true. When the consensus believes an investment is risk-free and everyone owns it, that enthusiastic demand has driven its price to a point where risk is highest.
- The best investors earn asymmetrical returns to the risk they take. They often have a track record of avoiding disasters.
- Risk management — risk control — is essential even when a potential risk isn’t obvious. It usually means forgoing some return to avoid any potential loss, even if the loss is never realized.
- It’s important to remember that history is only a rough guide to what’s possible. Better and worse outcomes can occur. Outliers are possible that break entirely from historical norms.
- “The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.”
- “Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”
- Economies, markets, and businesses rise and fall. It’s partially due to the involvement of people. Other factors are involved too but people reacting to those factors play a big role in the swings of cycles.
- Credit Cycle: “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.”
- “Understanding that cycles are eventually self-correcting is one way to maintain some optimism when bargain hunting after large market drops.” — Joel Greenblatt
- The mistake investors often make is believing a trend will continue, that a company will do well forever, and that the cycle is broken. Reversion is far more likely.
- “When things are going well, extrapolation introduces great risk. Whether it’s company profitability, capital availability, price gains, or market liquidity, things that inevitably are bound to regress toward the mean are often counted on to improve forever.”
- Markets resemble a perpetual pendulum, swinging back and forth between two extremes. At one extreme are euphoria, greed, optimism, risk-tolerance, and overpriced assets. At the other are depression, fear, pessimism, risk-aversion, and underpriced assets. The pendulum never stops at the midpoint of its swing or the “average.” It’s always swinging through it, towards one extreme or the other. It’s the swing of the pendulum that’s dependable. What’s less dependable — that keeps everyone guessing — is the rate, the speed, and power of the swing. We never know how far it swings, what causes it to reverse (or when or how quickly it reverses), and how far it swings back in the other direction.
- The primary risks in investing: Losing money and missed opportunities. It requires a balancing act for any portfolio (can’t eliminate both).
- 3 Stages of a Bull Market:
- “The first, when a few forward-looking people begin to believe things will get better”
- “The second, when most investors realize improvement is actually taking place”
- “The third, when everyone concludes things will get better forever”
- “Stocks are cheapest when everything looks grim.”
- 3 Stages of a Bear Market:
- “The first, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy”
- “The second, when most investors recognize things are deteriorating”
- “The third, when everyone’s convinced things can only get worse”
- “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.”
- Arbitraging human nature — exploited the common behavioral mistakes that lead to mispricing and inefficiencies in the market — can lead to above-average returns. Of course, it requires avoiding similar mistakes:
- Greed – the pursuit of profits above all else, without consideration of risk.
- Fear – prevents investors from making rational decisions and taking rational actions.
- A Tendency to Dismiss Logic – when investors accept unlikely outcomes as probable because they would get rich quick.
- Following the Herd – people, in general, are more comfortable following a group than going it alone…even when they know it’s the wrong decision.
- Envy – people compare themselves to others too much…that includes returns. It makes it hard to watch others make more money in the stock market without eventually acting on it.
- Ego – can lead to over-aggressive investing in the hopes of recognition, to show off high returns, or feel “smarter.” It leads to short term thinking. Humility is needed to keep the ego in check.
- Capitulation – the late behavior in all cycles is when the last holdouts give in and jump on the bandwagon.
- Inadequate Skepticism – the recurring phrase “too good to be true” is repeated after every market bubble. A magically investment or strategy that produces high returns without risk doesn’t exist. A skeptic separates what’s too good to be true from what sounds good.
- Fear of Being Wrong — when doubt pushes you to question your judgment on an investment because it declined in price (which is often the case when buying an underpriced asset) or you’re missing out on something that everyone else is making money on.
- “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” — Demosthenes
- “The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”
- “Many of the mistakes I have made are the same ones that I had made before; they just look a little different each time—the same mistake slightly disguised.” — Joel Greenblatt
- “Rising prices are a narcotic that affects the reasoning power up and down the line.” — Warren Buffett
- “The tendency to compare results is one of the most invidious. The emphasis on relative returns over absolute returns shows how psychology can distort the process.”
- “In my view, the road to investment success is usually marked by humility, not ego.”
- All bubbles start with a grain of truth.
- “To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.” — John Templeton
- Contrarianism means avoiding the repeated mistakes the herd makes at the extremes of the market cycle. The difficulty is in recognizing the extremes and then acting on it, knowing you’ll never time the bottom or top, or that prices can continue moving in the same direction longer than you might think.
- Outside of the extremes, contrarianism is less likely to be profitable.
- Experience might be the greatest teacher in recognizing the extremes of the market cycle.
- “Investment success requires sticking with positions made uncomfortable by their variance with popular opinion.” — David Swensen
- “Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.”
- “There are two primary elements in superior investing: seeing some quality that others don’t see or appreciate (and that isn’t reflected in the price), and having it turn out to be true (or at least accepted by the market).”
- Investors must think in terms of probabilities when dealing with the future — what could happen and how likely is it to happen.
- “Investment is the discipline of relative selection.” — Sid Cottle
- “Our goal isn’t to find good assets, but good buys. Thus, it’s not what you buy; it’s what you pay for it.”
- Where to find bargains?
- Something’s wrong — it looks bad on the surface like an over-leverage company, a failed project, or mismanagement.
- Misunderstood asset — investors don’t look deep enough to understand it and/or show a bias towards it.
- Highly unpopular – it’s ignored or scorned by the media, thus everyone else.
- Controversial or inappropriate for most portfolios.
- What’s being sold the most?
- Of course, its price is falling — leading first-level thinkers to avoid it.
- “Investment bargains needn’t have anything to do with high quality. In fact, things tend to be cheaper if low quality has scared people away.”
- “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.” — Peter Bernstein
- “Patient opportunism—waiting for bargains—is often your best strategy.”
- A common mistake investors make is to equate action with adding value to a portfolio. Increased action usually just leads to overtrading and lower returns. Instead, investors should wait for the “best” opportunities to come to them — that they’re willing to act on — rather than chasing after things that add nominal value but carry more risk. This can be made worse by trying to create opportunities that don’t exist. Doing nothing is the hardest part of investing but often the most necessary.
- Knowing what you don’t know is essential to investing success.
- Accurately anticipating change is the most profitable but also the most difficult to predict.
- One aspect of knowing what you don’t know is being careful with your own forecasts and those of others because nobody knows the future with absolute certainty.
- The biggest mistake investors make is forgetting the limits of their own knowledge. This includes mistaking the difference between probability and outcome.
- “Some of the biggest losses occur when overconfidence regarding predictive ability causes investors to underestimate the range of possibilities, the difficulty of predicting which one will materialize, and the consequences of a surprise.”
- If you know the future, it’s best to be aggressive, make concentrated bets, use leverage, time the market, and ignore risk — all the things great investors warn about. Because the greats don’t know the future, they are defensive, diversify, hedge, focus on value over price, emphasize risk management, and prepare for multiple outcomes.
- “Overestimating what you’re capable of knowing or doing can be extremely dangerous—in brain surgery, transocean racing or investing. Acknowledging the boundaries of what you can know—and working within those limits rather than venturing beyond—can give you a great advantage.”
- “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.” — Amos Tversky
- Rather than trying to figure out the future, try to figure out where we are in the market cycle, make adjustments if necessary when close to the extremes, and prepare mentally to avoid behavioral mistakes that plague investors throughout. The key is to watch for investor behavior that typically emerges, especially at the extremes of the cycle.
- Randomness or luck plays a bigger role in investing than most people want to admit. It’s how someone can bet on a long-shot lottery stock, win big, and look like a genius. But it has little to do with skill and a lot to do with luck. In the short run, any outcome is possible including the least probable. In the long run, bet hundreds or thousands of times, the total outcomes will approach what’s most probable.
- Investors’ decisions should be judged independent of the outcome because randomness allows for investors to make the wrong decision and still make money (or the right decision and lose). Process over outcomes is what matters.
- “For good investors, as the time horizon expands, which allows skill to come into play, the probability distribution of long-term returns should narrow.” — Joel Greenblatt
- A good investment strategy essentially has a dial that can adjust the balance between “making money” and “avoiding losses.” Of course, turning the dial requires rational thinking.
- The offensive investor is usually focused on aggressive investments/positions in order to outperform.
- The defensive investor is usually focused on avoiding mistakes and not doing the wrong thing that leads to losses. For defensive investors, that means avoiding investments that have a high probability of losses and avoiding overexposure to big drawdowns in a crash.
- “Here is part of the tradeoff with diversification. You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term.” — Joel Greenblatt
- A large margin of safety increases a portfolio’s tolerance for undesirable outcomes. A lower price — in relation to value — is the primary source of this margin. The lower the price, the wider the margin.
- “In fixed income…returns are limited and the manager’s greatest contribution comes through the avoidance of loss. Because the upside is truly “fixed,” the only variability is on the downside, and avoiding it holds the key. Thus, distinguishing yourself as a bond investor isn’t a matter of which paying bonds you hold, but largely of whether you’re able to exclude bonds that don’t pay. According to Graham and Dodd, this emphasis on exclusion makes fixed income investing a negative art.”
- With stocks, the upside isn’t fixed like bonds. So the investor must find a balance between offense and defense. Obviously, they must play defense to avoid the losers, but must also play offense for the higher return.
- “One way to maximize the asymmetry of risk and reward is to make sure you minimize risk. I’ve said this before in another place: if you minimize the chance of loss in an investment, most of the other alternatives are good.” — Joel Greenblatt
- “Investing scared, requiring good value and a substantial margin for error, and being conscious of what you don’t know and can’t control are hallmarks of the best investors I know.”
- “An investor needs to do very few things right as long as he avoids big mistakes.” — Warren Buffett
- Failure of Imagination – Marks defines it as the inability to come up with a full range of outcomes and/or not completely understanding the consequences of those outcomes. Specifically, it’s in reference to extreme outliers.
- “Short-run outcomes can diverge from the long-run probabilities, and occurrences can cluster.”
- Avoiding big losses means building a portfolio to protect from the possibility of unlikely terrible losses occurring.
- On asset correlation: “The failure to correctly anticipate co-movement within a portfolio is a critical source of investment error.”
- “…we always think in terms of earnings yield (which is just the inverse of the P/E) rather than in P/Es; doing so allows for easy comparison to fixed-income alternatives.” — Christopher Davis
- Lessons from a Crisis:
- Too much capital availability makes money flow to the wrong places.
- When capital goes 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.
- In heady times, capital is devoted to innovative investments, many of which fail the test of time.
- Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem.
- Psychological and technical factors can swamp fundamentals.
- Markets change, invalidating models.
- Leverage magnifies outcomes but doesn’t add value.
- Excesses correct.
- “Most of these eleven lessons can be reduced to just one: be alert to what’s going on around you with regard to the supply/demand balance for investable funds and the eagerness to spend them.”
- The biggest mistake investors make is selling at the bottom and missing the recovery.
- “When there’s nothing particularly clever to do, the potential pitfall lies in insisting on being clever.”
- “Asymmetry—better performance on the upside than on the downside relative to what your style alone would produce—should be every investor’s goal.”
- Any expectation of investment returns should be reasonable.
- Every investor should have a return goal in mind, know the amount of risk they can tolerate, and the amount of liquidity their strategy requires.
- “Perfection in investing is generally unobtainable; the best we can hope for is to make a lot of good investments and exclude most of the bad ones.”
