The Most Important Thing

A book on investment philosophy by Howard Marks.

There is no one most important thing. Howard Mark's list of eighteen most important things are ALL important. They must be thought about all at the same time when investing. Investing is a complex activity.

"These are the guideposts that keep me on track."

"A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources. One cannot develop an effective philosophy wihtout having been exposed to life's lessons."

In other words, one develops a style- or a philosophy- from wisdom. This is what makes each individual unique because everyone is exposed to different ideas over the course of one's lifetime.

"Experience is what you got when you didn't get what you wanted."

In other words, one only learns from experiencing pain and failure.

Second Level Thinking

In investing, no single rule always works. The environment and circumstances never repeats exactly. (This reminds me of chaos theory where small differences in initial conditions generate huge differences in results over time.)

Everyone can accomplish average investment returns- by investing in index funds. But successful investors want more. They want to beat the market.

Millions compete in the market to generate superior returns, but not everyone can be superior. Who'd win? The ones who are a step ahead, the ones with superior insight and intution. This is the second level thinking.

Others are well armed with information and computer algorithsm. To do better than average, you must have something they do not. You must be more right than others. You must be different.

First level thinking is "this company is good, let's buy it." Second level thinking is "this company is good, let's buy it- but everyone knows it's a good company. It's overrated and overpriced, let's sell it."

Second level thinking is deep, complex and convoluted. It sounds more like 3D chess- where you're thinking many moves ahead. First level thinking is the most simple and direct move, but SLT is thinking further down the horizon. The workload required for SLT is tremendously greater than for FLT.

Conventional first level thinking, following the herd, leads to average to mediocre performance. Supeior performance requires thinking other than the consensus. It requires you to think different.

First level thinkers think the same way the other first level thinkers do- and they reach the same conclusions. This cannot beat the market because collectively, they are the market.

To achieve superior results, you have to hold nonconsensus (different) views regarding value and they have to be different.

Agreeing with the broad view will not lead to superior results.

Market Efficiency

EMT (Efficient Market Theory) says there are many participants in the market with equal access to all relevant information. Their collection actions drive market prices to reflect all that is known in the market.

Prices already reflect the consensus. Holding the consensus view then brings an average return.

EMT states that superior returns can be achieved by taking on additional risks.

Another ramification of EMT is to give up seeking for superior investments - just invest in a basket of assets, or an index.

Howard Marks says EMT cannot be dismissed- and its conclusions are probably true for asset classes that are efficient- where information is publicly known for all investors.

However, second level thinkers thrive on inefficiency. They must find an edge in information or analysis that no one else knows or believes.

An inefficient market is a market that does not contain all known information and can be taken advantage of.

No market is completely 100% efficient or 100% inefficient. The market efficiency dynamically ranges in between extremes at all times.

A market can be inefficient at times- and that's when opportunities sprout up. But at those times, you have to ask questions such as - why haven't others picked up and acted on the same information or analysis?

"I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best."

Value

Howard Marks doesn't believe in technical analysis or momentum investing.

"Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, 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. And third: you have to be right"

Price and Value

Let's say you're able to come up with an estimate of intrinsic value for a stock or other asset. Let's even say your estimate is right. You're not done. In order to know what action to take, you have to look at the asset's price relative to its value."

Howard Marks mentions a investor psychology as a power factor on price.

"Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals."

"The key is who likes the investment now and who doesn't. Future price changes will be determined by whether it comes to be liked by more people or fewer people in the future."

"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."

Understanding Risk

"Theory says high return is associated with high risk because the former exists to compensate for the latter. But pragmatic value investors feel just the opposite. They believe high return and low risk can be achieved simulatenously by buying things for less than they're worth. In the same way, overpaying implies both low return and high risk."

Let's aim for buying something with good value at a low price.

"Riskier investments are those for which the outcome is less certain. That is, the probabily distribution of returns is wider. When priced fairly, riskier investments should entail: - higher expected returns - the possibility of lower returns, and - in some cases, the possibility of losses"

The traditional graph where higher risk means higher returns is not totally correct. A high return for higher risk is only one possible outcome for a range of possible outcomes. Other possible outcomes are higher losses. A higher risk asset has a wider range of possible outcomes.

"The most common bell-shaped distrbiution is called the 'normal' distribution. However, people often use the terms bell-shaped and normal interchangeably and they're not the same. The former is a general type of distribution, while the latter is a specific bell-shaped distribution with very definite statistical properties."

"In the years leading up to the crisis, financial engineers, or 'quants' played a big part in creating and evaluating financial products such as deriatives and structured entitites. In many cases they made the assumption that future events would be normally distributed. But the normal distribution assumed events in the distant tails will happen extremely infrequently, while the distribution of financial developments- shaped by humans, with their tendancy to go to emotion-driven extremes of behavior- should probably be seen as having 'fatter' tails. Thus, when widespread mortgage defaults began to occur, events thought to be unlikely befell mortgage-related vehicles on a regular basis. Investors in vehicles that had been constructed on the basis of normal-distributions, without much allowance for 'tail events' (black swans) often saw the wheels come off.

Investors run for the exits at the same time, and that's when extremes happen. This almost relates to the motion of fluids or people in crowded streets. When both achieve a critical mass, disasters happen.

"There's a big difference between probability and outcome. Probable things fail to happen- and improbable things happen- all the time."

"Most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has set things up to look like that'll be the case; if it didn't, people wouldn't make risky investments. But it can't always work that way, or else risky investments wouldn't be risky. And when risk bearing doesn't work, it really doesn't work, and people are reminded what risk's all about."

Recognizing Risk

"Risk means uncertainty about which outcome will occur and the possibility of loss when the unfavorable ones do."

High risk comes from paying too much- when the market sentiment is extremely bullish. This means there is less risk when paying far from the top.

"The risk-is-gone myth is one of the most dangerous sources of risk and a major contributor to any bubble. At the extreme of the pendulums's upswing, the belief that risk is low and that the investment in question is sure to produce profits intoxicates the herd and cuases its members to forget caution, worry and fear of loss, and instead to obsess about the risk of missing opportunity."

This comment is true for every bubble and subsequent crash.

"The recent crisis came about primarily because investors partook of novel, complex and dangerous things, in greater amounts than ever before. They took on too much leverage and committed too much capital to illiquid investments. Why did they do these things? It all happened because investors believed too much, worried too little, and thus took too much risk. In short, they believed they were living in a low-risk world."

"When everyone believes something embodies no risk, they usually bid it up to the point where it's enormously risky. No risk is feared, and thus no reward for risk bearing- no 'risk premium'- is demanded or provided. That can make the thing that's most esteemed the riskiest.

The opposite is also true.

"When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it's not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price."

Controlling Risk

What is risk?

"Risk is the uncertainty about which outcome will occur- and the possibility of loss when the unfavorable ones occur."

Where does risk come from?

"The greatest risk doesn't come from low quality or high volatility. It comes from paying prices that are too high."

"The value investor thinks of high risk and low prospective returns as nothing but two sides of the same coin."

The greatest risk is ignoring risk when times have been good for too long.

"In bull markets- usually when things have been going well for a while- people tend to say, 'Risk is my friend. The more risk I take, the greater my return will be. I'd like more risk, please.... When people aren't afraid of risk, they'll accept risk without being compensated for doing so...and risk compensation will disappear."

"Worry and its reslatives, distrust, skeptism, and risk aversion, are essential ingredients in a safe financial system,"