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Book cover of The Most Important Thing by Howard Marks

The Most Important Thing by Howard Marks
Uncommon Sense for the Thoughtful Investor

My Thoughts

Howard Marks is one of my favorite writers on investing. This book is a compilation of many of his memos organized into 19 “most important” concepts. These insights are especially relevant today because of what is happening in the economy and the stock market.

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My Favorite Quotes

  • Risk is the most interesting, challenging, and essential aspect of investing.
  • Experience is what you got when you didn’t get what you wanted.
  • No idea can be any better than the action taken on it.
  • Being too far ahead of your time is indistinguishable from being wrong.
  • Elevated popular opinion is the source of low return potential and high-risk.
  • The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.
  • 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
  • Large amounts of money are not made by buying what everyone likes, they are made by buying what everybody underestimates.
  • The relationship between price and value holds the ultimate key to investment success. Buying below value is the most dependable route to profit.

Key Questions

  • What is the range of likely future outcomes?
  • Which outcome do I think will occur?
  • What is the probability that I’m right?
  • What does the consensus think?
  • How does my expectation differ from the consensus?
  • How does the current price for the asset comport with the consensus view of the future and with mine?
  • Is the consensus psychology that is incorporated in the price too bullish or bearish?
  • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
  • How is one to find bargains within efficient markets?
  • Have mistakes in pricings been driven out through investors’ concerted efforts, or do they still exist, and why?
  • If the return appears so generous in proportion to the risk, might there be some hidden risk I am overlooking?
  • Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
  • Do I really know more about the asset than the seller does?
  • How often in our business are people right for the wrong reason?
  • Are forecasters as a whole, or any one person’s forecasts, consistently actionable and valuable?


The goal of the book is to share ideas and ways of thinking about investing that you haven’t come across before. Howard would like you to walk away from this book saying “I never thought of it that way.”

He spends more time discussing risk and how to limit it, than how to achieve investment returns.

To Howard Marks, risk is the most interesting, challenging, and essential aspect of investing.

This is Howard’s response to the question “What have been the keys to your success?”

“An effective investment philosophy developed and honed over more than four decades, and implemented conscientiously by highly skilled individuals who share culture and values.

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 without having been exposed to the lessons of life.

Howard spent time at two great business schools that provided a very effective and provocative combination of experience.

  • Qualitative “nuts and bolts” education in pre-theory days at Wharton.
  • Quantitative theoretical education at the graduate school of business at the University of Chicago.

You must be aware of what is taking place in the world and what results those events lead to.

Experience is what you got when you didn’t get what you wanted. Good times teach only bad lessons: that investing is easy, that you know it’s secrets, and that you need not worry about risk.

By reading widely, you can learn from people whose ideas merit publishing.
Some of the most important books for Howard Marks were:

  • A Short History of Financial Euphoria by John Kenneth Galbraith
  • Fooled by Randomness by Nassim Nicholas Taleb
  • The Loser’s Game article published by Charlie Ellis in the Financial Analyst’s Journal July-August 1975.

No idea can be any better than the action taken on it.

Chapter 1: The Most Important Thing Is…Second-Level Thinking

Investing is as much art as it is science.

It is essential that one’s investment approach is intuitive and adaptive rather than fixed and mechanistic.

Anyone can achieve average returns, just invest in an index fund that buys a little of everything. That will give you market returns.

Successful investors want more than market returns, they want to beat the market.

The definition of successful investing according to Howard Marks: doing better than the market and other investors.

To achieve above-average results requires second-level thinking.

If you want to do better than average, your thinking has to be better than that of others, both more powerful and at a higher level.

What is second-level thinking?

First-level thinking says “It’s a good company, let’s buy the stock!”
Second-level thinking says “It’s a good company, but everyone thinks its a great company and its not. So the stock is overrated and overpriced, let’s sell.”

First-level thinking is simplistic and superficial, and just about everyone can do it.
Second-level thinking is deep, complex and convoluted.

A second-level thinker takes many of these things into account:

  • What is the range of likely future outcomes?
  • Which outcome do I think will occur?
  • What is the probability that I’m right?
  • What does the consensus think?
  • How does my expectation differ from the consensus?
  • How does the current price for the asset comport with the consensus view of the future and with mine?
  • Is the consensus psychology that is incorporated in the price too bullish or bearish?
  • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

The difference in workload between first and second level thinking is massive.

First-level thinkers look for simple formulas and easy answers.

How is one to find bargains within efficient markets? You must bring exceptional analytical ability, insight, or foresight.

Chapter 2: The Most Important Thing Is…Understanding Market Efficiency

The efficient-market hypothesis states that asset prices reflect all available information immediately.

Howard agrees that asset prices immediately reflect the consensus view of the information available. He does not, however, believe that the consensus view is necessarily correct.

For example, Yahoo shares sold at $237 in January 2000, and in April 2001 it was at $11, the market had to be wrong on at least one of those occasions.

Sharing the consensus view will make you likely to earn just an average return.

Second-level thinkers depend on inefficiency.

Most people are driven by fear, greed, envy, and other emotions that render objectivity impossible and open the door for significant mistakes.

Market inefficiency is a necessary condition for the outperformance of the market but does not guarantee it.

Market prices are often wrong. They are often far above or far below intrinsic values.

Respect for efficiency says that before we embark on a course of action, we should ask some questions:

  • Have mistakes in pricings been driven out through investors’ concerted efforts, or do they still exist, and why?
  • If the return appears so generous in proportion to the risk, might there be some hidden risk I am overlooking?
  • Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
  • Do I really know more about the asset than the seller does?

Chapter 3: The Most Important Thing Is…Value

An accurate estimate of intrinsic value is the indispensable starting point of successful investing.

The oldest rule in investing is “Buy low; sell high.”
What does that rule actually mean?
Buy at a price below intrinsic value and sell at a higher price.

All approaches to investing in company securities can be divided into two basic types:

  1. Those based on analysis of the company’s attributes, known as fundamentals.
  2. Those based on a study of the price behavior of the securities themselves.

Howard does not believe in this second method, and calls it “momentum investing.”

Two approaches to investing based on analysis of the company’s fundamentals:

  1. Value Investing: aim to come up with the company’s current intrinsic value and buy when the price is lower.
  2. Growth Investing: try to find securities whose value will increase rapidly in the future.

The emphasis in value investing is on tangible factors like hard assets and cash flows, intangible factors are given less weight.

The primary goal of value investors is to quantify the company’s current value and buy its securities when they can do so cheaply.

Growth investors buy stocks because they believe the value will grow fast enough in the future to produce a substantial appreciation.

Growth investing centers around big winners. The batting average for growth investors should be lower, but the payoff for doing it well might be higher.

The upside potential for being right about growth is more dramatic, and the upside potential for being right about value is more consistent.

Value investing is Howard’s approach, in his book consistency trumps drama.

In the world of investing, being correct is not synonymous with being proved correct right away.
It is impossible to consistently do the right thing at the right time as an investor.
The most a value investor can hope for is to be right about an asset’s value and buy when it is available for less.

If doing the right thing as a value investor, you will often find that you’ve bought in the midst of a decline that continues. Pretty soon you will be looking at losses.

Being too far ahead of your time is indistinguishable from being wrong.

An accurate opinion on valuation loosely held will be of little help. An incorrect opinion on valuation strongly held is far worse. This shows how hard it is to get it all right.

Two essential ingredients for profit in a declining market:

  1. You have to have a view on intrinsic value.
  2. You have to hold that view strongly enough to be able to hang-in and buy even as price declines suggest that you are wrong.
  3. You have to be right.

Chapter 4: The Most Important Thing Is…The Relationship Between Price and Value

Price has to be the starting point for a value investor. No asset is so good that it can’t become a bad investment if bought at too high a price. There are few assets so bad that they can’t become a good investment if bought cheap enough.

It takes a lot of hard work or luck to turn something bought at too high of a price into a successful investment.

In the era of the “nifty fifty“, many of those companies traded at a price-to-earnings (P/E) ratio between 80 and 90. By comparison, the post-war average P/E ratio of stocks, in general, has been in the mid-teens.

What goes into the price?
The underlying fundamental value of course.
Most of the time, the short-term fluctuation of a security’s price will be determined by two other factors:

  1. Psychology
  2. Technicals

Most investors no little about technicals.
Technicals are non-fundamental factors (things unrelated to value) that affect the supply and demand for securities.

Two examples of technicals:

  1. The forced selling that takes place when market crashes cause levered investors to receive margin calls and be sold out.
  2. The inflows of cash to mutual funds that require portfolio managers to buy.

Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity.

The safest and most potentially profitable thing is to buy something when no one likes it.

You must invest the time and energy to understand market psychology.

The fundamental value will be only one of the factors determining a security’s price on the day you buy it.

Chapter 5: The Most Important Thing Is…Understanding Risk

Investing consists of dealing with the future. Thus dealing with risk is an essential, I think the essential, element in investing.

Steps in dealing with risk:

  • Step 1: Understanding it. (Chapter 5)
  • Step 2: Recognizing when it is high. (Chapter 6)
  • Step 3: Controlling it. (Chapter 7)

Three powerful reasons that risk assessment is such an essential element of the investment process:

  1. Risk is a bad thing, and most level-headed people want to avoid or minimize it.
  2. When you are considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher potential returns to take incremental risks.
  3. When you consider investment results, the return means only so much by itself. The risk taken has to be accessed as well. Was the return achieved in safe investments or risky ones?

Defining Risk

The next major task is to define risk. What does risk involve?

This section is from the January 19, 2006 memo “Risk.”

Volatility is not necessarily risky. Risk is, first and foremost, the likelihood of losing money.

Aside from the risk of permanent loss of money. There are many other kinds of risks that you should be aware of because they can either affect you or affect others and present you with opportunities for profit.

Investment risk comes in many forms. Many risks matter to some investors but not to others. They may make a given investment seem safe for some and risky for others.

Other forms of risk:

  • Falling short of one’s goal
  • Underperformance
  • Career risk (the extreme form of underperformance)
  • Unconventionality
  • Illiquidity

Falling Short of One’s Goal
4% returns can be good for one type of investor while 6% returns could be terrible for another investor with different goals.

Failure to keep up with a benchmark index.
The best investors can have some of the greatest periods of underperformance. Specifically in crazy times disciplined investors willingly accept the risk of not taking enough risk to keep up.

Career Risk
Fund managers may not be concerned about gains but can be deathly afraid of losses that could cost them their jobs.

Risk of being different.
Stewards of other people’s money can be more comfortable turning in average performance, regardless of where it stands in absolute terms, then with the possibility of being unconventional and getting fired.

Being unable, when needed, to turn an investment into cash at a reasonable price.

What Gives Rise to the Risk of Loss?

  1. The risk of loss does not necessarily stem from weak fundamentals.
  2. Risk can be present even without weakness in the macro-environment.
  3. Risk is deceptive.

Risk mostly comes down to psychology that is too positive, and thus prices that are too high.

Value investors believe high return and low risk can be achieved simultaneously by buying things for less than they are worth. In the same way, overpaying implies both low return and high risk.

How do investors measure risk?

  1. It clearly is nothing but a matter of opinion.
  2. The standard for quantification is nonexistent.

Everyone measures risks differently.

Skillful investors can get a sense of the risk present in a given situation. They make that judgment primarily based on the stability and dependability of value, and the relationship between price and value.

Investors who want some objective measure of risk-adjusted return can only look to the so-called Sharpe ratio.

How often in our business are people right for the wrong reason?
Nassim Taleb calls these people “lucky idiots” and in the short-term, it is hard to tell them apart from skilled investors.

Even after an investment has been closed out, it is impossible to tell how much risk it entailed.

Risk means more things can happen than will happen.
Risk is largely a matter of opinion.

Return alone, especially over short periods of time, says very little about the quality of investment decisions.

Chapter 6: The Most Important Thing Is…Recognizing Risk

Risk increases during upswings, as financial imbalances build up, and materializes during downswings.

Great investing requires both generating returns and controlling risk. Recognizing risk is an absolute prerequisite for controlling it.

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

The process through which risk can be recognized for what it is

High risk comes primarily along with high prices. Participating when prices are high, rather than shying away, is the main source of risk.

Awareness of the relationship between price and value is an essential component of dealing successfully with risk. Dealing with risk starts with recognizing it.

Risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risks without being compensated for doing so, and risk compensation will disappear.

The degree of risk present in the market derives from the behavior of the participants.
Risks will be low only if investors behave prudently.

“The risk is gone” myth is one of the most dangerous sources of risk, and a major contributor to any bubble.

Investment risk comes primarily from too high prices, and too high prices often come from excessive optimism and inadequate skepticism and risk aversion.

The herd is wrong about risk at least as often as it is about the return. A broad consensus that something is too hot to handle is almost always wrong. Investment risk resides most where it is least perceived and vise versa.

When everyone believes something is risky, their unwillingness to buy usually reduces the price to the point where it is not risky at all. All optimism has been driven out of its price.

Most investors think quality, as opposed to price, is the determinant of whether something is risky. High-quality assets can be risky, and low quality assets can be safe, it is just a matter of the price paid for them.

Elevated popular opinion is the source of low return potential and high-risk.

Chapter 7: The Most Important Thing Is…Controlling Risk

Risk control is invisible in good times. Risk is not observable but loss is.
The absence of loss does not mean the portfolio was safely constructed.

Fundamental risk reduction can provide the foundation for an extremely successful investing experience.

There is an important distinction between risk control and risk avoidance.
Risk control is the best route to loss avoidance.
Risk avoidance is likely to lead to return avoidance as well.

Strive for risk intelligence.

Chapter 8: The Most Important Thing Is…Being Attentive to Cycles

This section is primarily from the November 20, 2001 memo “You can’t predict. You can prepare.”

Remember that just about everything is cyclical.

Two concepts we can hold to with confidence:

  1. Most things will prove to be cyclical.
  2. Some of the greatest opportunities for gain and loss come when other people forget rule #1.

When people are involved, results are variable and cyclical.
When things are going well, people spend more and save less.

Trends create the reason for their own reversal.
Success carries within itself the seeds of failure, and failure the seeds of success.

The Credit Cycle

Of all the cycles, this is Howard’s favorite.
The credit cycle deserves special attention for its inevitability, extreme volatility, and ability to create opportunities for investors attuned to it.

The longer I’m involved in investing, the more impressed I am by the power of the
credit cycle. It takes only a small fluctuation in the economy to produce a large
fluctuation in the availability of credit, with great impact on asset prices and back
on the economy itself.

The credit cycle process:

  1. The economy moves into a period of prosperity.
  2. Providers of capital thrive, increasing their capital base.
  3. Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.
  4. Risk averseness disappears.
  5. Financial institutions move to expand their businesses – that is, to provide more capital.
  6. They compete for market share by lowering demanded returns (e.g., cutting interest
    rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.

This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.

When this point is reached, the up-leg described above is reversed.

  1. Losses cause lenders to become discouraged and shy away.
  2. Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.
  3. Less capital is made available – and at the trough of the cycle, only to the most
    qualified of borrowers.
  4. Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
  5. This process contributes to and reinforces the economic contraction.

Cycles are self-correcting. 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.

Investors overvalue companies when they are doing well, and undervalue them when things get difficult.

It is dangerous when the market is at record highs, to reach for a positive rationalization that has never held true in the past.

Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.

Chapter 9: The Most Important Thing Is…Awareness of the Pendulum

The mood swings of the securities markets resemble the swing of a pendulum. They swing between the following:

  • Between euphoria and depression
  • Between celebrating positive developments and obsessing over negatives
  • Between overpriced and under-priced

The main risks in investing:

  1. The risk of losing money
  2. The risk of missing opportunity

It is possible to largely eliminate either one, but not both.

Three stages of a bull market:

  1. A few forward-looking people begin to believe things will get better.
  2. Most investors realize improvement is taking place.
  3. Everyone concludes things will get better forever.

Three stages of a bear market:

  1. A few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy.
  2. Most investors realize things are deteriorating.
  3. Everyone is convinced things can only get worse.

In the darkest times, it takes analytical ability, objectivity, resolve, and imagination to think things will ever get better. The few people who possess those qualities can make unusual profits with low risk.

Chapter 10: The Most Important Thing Is…Combating Negative Influences

Universal factors that have a profound collective impact on most investors and markets:

  • The desire for more
  • The fear of missing out
  • The tendency to compare against others
  • The influence of the crowd
  • The dream of the sure thing

These factors will lead to investing mistakes and provide opportunities for superior performance. Exploiting these is the only road to consistent outperformance.

Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology.

The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.

The danger comes when the desire for money becomes greed.
Greed is strong enough to overcome common-sense, risk aversion, prudence, caution, logic, resolve, trepidation, and all the other elements that might keep investors out of trouble.

What weapons can you have on your side to increase your odds of combating psychological influences?

  • A strongly held sense of intrinsic value.
  • Insistence on acting as you should when price diverges from value.
  • Enough conversance with past cycles, gained at first from reading and talking to veteran investors, and later through experience, to know that market-excesses are ultimately punished, not rewarded.
  • A thorough understanding of the insidious effect of psychology on the investing process at market extremes.
  • A promise to remember that when things seem too good to be true, they usually are.
  • Willingness to look wrong while the market goes from miss-valued to more miss-valued as it invariably will.
  • Likeminded friends and colleagues from whom to gain support, and for you to support.

Chapter 11: The Most Important Thing Is…Contrarianism

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

Most investors are trend followers. Superior investors are the exact opposite.

Market extremes represent inflection points.

Once-in-a-lifetime market extremes seem to occur once every decade or so. Not often enough for an investor to build a career around capitalizing on them. Attempting to do so should be an important component of any investor’s approach.

Markets can be overpriced or underpriced and stay that way for years. It can be extremely painful when the trend is going against you.

Large amounts of money are not made by buying what everyone likes, they are made by buying what everybody underestimates.

Two elements required in superior investing:

  1. Seeing some quality that others don’t see or appreciate, and that isn’t reflected in the price.
  2. Having it turn out to be true.

The section below is primarily from the October 15, 2008 memo “The Limits to Negativism.”

If you believe the story everyone else believes, you’ll do what they do, you will buy at high prices and sell at low prices.

I’d define skepticism as not believing what you’re told or what “everyone” considers true. In my opinion, it’s one of the most important requirements for successful investing.

Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.

The herd applies optimism at the top and pessimism at the bottom. Thus, to benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom.

Sometimes skepticism requires us to say “No, that’s too bad to be true.”

A hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.

Chapter 12: The Most Important Thing Is…Finding Bargains

The process of intelligently building a portfolio consists of buying the best investments. Making room for them by selling lesser ones, and staying clear of the worst.

The raw materials for the process consist of:

  1. A list of potential investments.
  2. Estimates of their intrinsic value.
  3. A sense for how their prices compare with their intrinsic value.
  4. An understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.

Create a list of investment candidates meeting a set of minimum criteria, and from those chose the best bargains.

Potential bargains usually display an objective defect.

Bargains are usually based on irrationality or incomplete understanding.

Bargains can be created when an entire asset class goes out of style.

Fairly priced assets are never our objective since it’s reasonable to conclude they’ll deliver just fair returns for the risk involved.

Our goal is to find underpriced assets.
Where should we look for them?
A good place to start is among things that are:

  • Little known and not fully understood.
  • Fundamentally questionable on the surface.
  • Controversial, unseemly, or scary.
  • Deemed “inappropriate” for “respectable” portfolios.
  • Unappreciated, unpopular, and unloved.
  • Trailing a record of poor returns.
  • Recently the subject of disinvestment, not accumulation.

Since bargains provide value at unreasonably low prices, and thus unusual ratios of return to risk, they represent the holy grail for investors.

Chapter 13: The Most Important Thing Is…Patient Opportunism

There aren’t always great things to do. Sometimes we maximize our contribution by being discerning and relatively inactive. Patient opportunism, waiting for bargains, is often your best strategy.

You’ll do better if you wait for investments to come to you, rather than go chasing after them.

You tend to get better buys if you select from the list of things sellers are motivated to sell, rather than start with a fixed notion of what you want to own.

It is essential for investment success that we recognize the condition of the market and decide on our actions accordingly. The other possibilities are:

  1. Acting without recognizing the market’s status.
  2. Acting with indifference to the market’s status.
  3. Believing we can somehow change the market’s status.

These options are most unwise.

Missing a profitable opportunity is of less significance than investing in a loser.

You cannot insist on producing high returns in low-return environments. You simply cannot create investment opportunities when they are not there.

When prices are high, it is inescapable that prospective returns are low and risks are high.

The absolute best buying opportunities come when asset holders are forced to sell.
From time to time, holders become forced sellers for reasons like these:

  • The funds they manage experience withdrawals
  • Their portfolio holdings violate investment guidelines such as minimum credit ratings or position maximums.
  • They receive margin calls because the value of their assets fails to satisfy requirements agreed to in contracts with their lenders.

Forced sellers have no choice, they have to sell regardless of price.

The key during a crisis is to be:

  1. Insulated from the forces that require selling.
  2. Positioned to be a buyer instead.

To satisfy these criteria, an investor needs the following things:

  1. Staunch reliance on value.
  2. Little or no use of leverage.
  3. Long-term capital.
  4. A strong stomach.

Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.

Chapter 14: The Most Important Thing Is…Knowing What You Don’t Know

“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” ― John Kenneth Galbraith

The more we concentrate on smaller picture things, the more it is possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities. That is much less likely with regard to markets and economies.

People should try to know the knowable.

Content of this chapter comes primarily from these two memos:

It is possible to be right about the macro future once in a while, but not on a regular basis.

On balance, forecasts are of very little value.

The key question is not “Are forecasters sometimes right?” But rather, “Are forecasters as a whole, or any one person’s forecasts, consistently actionable and valuable?” Nobody should bet much on an affirmative answer.

Acknowledging the boundaries of what you can know, and working within those limits rather than venturing beyond, can give you a great advantage.

Chapter 15: The Most Important Thing Is…Having a Sense for Where We Stand

Market cycles present the investor with a daunting challenge because:

  • Their ups and downs are inevitable.
  • They will profoundly influence our performance as investors.
  • They are unpredictable as to the extent and especially timing.

What are we to do about cycles?

First possibility: rather than accept that cycles are unpredictable, we should redouble our efforts to predict the future. (this is a bad idea)

The second possibility: accept that the future isn’t knowable, throw up our hands and simply ignore cycles. Invest with total disregard for cycles. This is the “buy and hold” approach.

The third possibility: this is the right option by a wide margin, in Howard Mark’s opinion. Try to figure out where we stand in terms of each cycle, and what that implies for our actions.

In the world of investing, nothing is as dependable as cycles.

If we can’t know in advance how and when the turns will occur, how can we cope?

  1. Stay alert for occasions when a market has reached an extreme.
  2. Adjust our behavior in response.
  3. Refuse to fall into line with the herd behavior that renders so many investors dead-wrong at tops and bottoms.

Be alert to what is going on.
Take the temperature of the market.
Strive to understand the implications of what is going on around us.

Look around and ask yourself:

  • Are investors optimistic or pessimistic?
  • Do the media talking heads say the markets should be piled into or avoided?
  • Are novel investment schemes readily accepted or dismissed out of hand?
  • Are securities offerings and fund openings being treated as opportunities to get rich, or possible pitfalls?
  • Has the credit cycle rendered capital readily available, or impossible to obtain?
  • Are price/earnings ratios high or low in the context of history?
  • Are yield spreads tight, or generous?

Chapter 16: The Most Important Thing Is…Appreciating the Role of Luck

The truth is, much in investing is ruled by luck.

Howard considers the book Fooled by Randomness by Nassim Nicholas Taleb, one of the most important books an investor can read.

Outcomes that hinge on random events should be viewed differently from those that do not.

When things go right, luck looks like skill.
Investors are right and wrong all the time for the wrong reason.

A good decision is one that is optimal at the time it was made when the future is unknown. Thus correct decisions are often unsuccessful and vise vera. The quality of a decision is not determined by the outcome.

Chapter 17: The Most Important Thing Is…Investing Defensively

You cannot simultaneously go all-out for profit-making and loss-avoidance. Each investor has to take a position regarding these two goals and strike a reasonable balance.

Oaktree’s preference for defense is clear.
In good times it is okay to just keep up with the indices.
In bad times they are set up to outperform the markets.

Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.

Defensive investing is an attempt at higher returns more through the avoidance of minuses than the inclusion of plusses. More through consistent but perhaps moderate progress, than through occasional flashes of brilliance.

Two principal elements in investment defense:

  1. The exclusion of losers from portfolios.
  2. The avoidance of poor years, and especially exposure to meltdown in crashes.

The exclusion of losers from portfolios is best accomplished by:

  • Conducting extensive due diligence
  • Applying high standards
  • Demanding a low price and generous margin for error
  • Being less willing to bet on continued prosperity, rosy forecasts, and developments that may be uncertain

The avoidance of poor years, and especially exposure to meltdown in crashes requires:

  • Thoughtful portfolio diversification
  • Limits on the overall riskiness borne
  • A general tilt towards safety

Concentration and leverage are two examples of offense.

Low price is the ultimate source of margin for error.

Chapter 18: The Most Important Thing Is…Avoiding Pitfalls

“An investor needs to do very few things right as long as he avoids big mistakes.” -Warren Buffett

To avoid losses, we need to understand the pitfalls that create them.

Sources of error are primarily analytical/intellectual or psychological/emotional.

Psychological forces are some of the most interesting sources of investment error.
How are investors harmed by these forces?

  • By succumbing to them
  • By participating unknowingly in markets that have been distorted by others’ succumbing
  • By failing to take advantage when those distortions are present

If you buy when price exceeds the intrinsic value, you’ll have to be extremely lucky. The asset will have to go from overvalued to even more overvalued in order to experience gain rather than loss.

Average investors are fortunate if they can avoid pitfalls, superior investors look to take advantage of them.

An example of not taking advantage of a pitfall is failing to short an overvalued stock. This is an error of omission.

The first step in avoiding pitfalls is being on the lookout for them.

What we learn from a crisis, or ought to:
Read more details on page 10 of the memo No Different This Time, December 17, 2007.

  1. Too much capital availability makes money flow to the wrong places.
  2. When capital goes where it shouldn’t, bad things happen.
  3. When capital is in over-supply, investors compete for deals by accepting low returns and a slender margin for error.
  4. Widespread disregard for risk creates great risk.
  5. Inadequate due diligence leads to investment losses.
  6. In heady times, capital is devoted to innovative investments, many of which fail
    the test of time.
  7. Hidden fault lines running through portfolios can make the prices of seemingly
    unrelated assets move in tandem.
  8. Psychological and technical factors can swamp the fundamentals.
  9. Markets change, invalidating models.
  10. Leverage magnifies outcomes but doesn’t add value.
  11. Excesses correct.
  12. Investment survival has to be achieved in the short run, not on average in the long run.

What could investors have done leading up to the 2008 investment crisis?

  1. Take note of the carefree incautious behavior of others
  2. Prepare psychologically for a downturn
  3. Sell assets or at least the more risk-prone ones
  4. Reduce leverage
  5. Raise cash
  6. Tilt portfolios towards increased defensiveness

The usual ingredients of investment error:

  • Data or calculation error in the analytical process leads to an incorrect appraisal of value.
  • The full range of possibilities or their consequences is underestimated.
  • Greed, fear, envy, ego, suspension of disbelief, or some combination of these moves to an extreme.
  • Prices diverge significantly from value, and investors fail to notice this divergence.

Other possible investment mistakes to try to avoid:
From Risk and Return Today, October 27, 2004.

  • Not buying
  • Not buying enough
  • Not making one more bid in an auction
  • Holding too much cash
  • Not using enough leverage
  • Not taking enough risk

You must be aware of the times for aggression and the times for caution.

Chapter 19: The Most Important Thing Is…Adding Value

The purpose of this chapter is to explain what it means for skillful investors to add value.

A lot of this section is from the memo Returns and How They Get That Way, November 11, 2002.

Two terms from investment theory:

  • Beta: a measure of a portfolio’s relative sensitivity to market movements.
  • Alpha: personal investment skill, or the ability to generate performance that is unrelated to the movement of the market (this is alpha as defined by Howard).

It is easy to achieve the market return by holding a passive index fund.
All equity investors start with the possibility of simply emulating an index.

Pro-risk, aggressive investors should be expected to make more than the index in good times, and lose more in bad times.

The formula for explaining portfolio performance (Y) is as follows:
Y = A + BX
A is the symbol for Alpha, B stands for Beta, and X is the return of the market.
The market-related return of the portfolio is equal to its beta times the market return.

In my opinion, superior returns come most dependably from buying things for less
than they’re worth and benefiting from the movement of price from discount to fair
value. Making money this way doesn’t require increases in intrinsic value, which
are uncertain, or the attainment of prices above intrinsic value, which is irrational.

Chapter 20: The Most Important Thing Is…Pulling It All together

The best foundation for a successful investment, or a successful investment career, is value.

You must have a good idea of what the thing you’re considering buying is worth.
To achieve superior investment results, your insight into value has to be superior.

Only a strong sense of value will give you the discipline needed to take profits on a highly appreciated asset that everyone thinks will rise non-stop. Or the guts to hold and average down in a crisis even as prices go lower every day.

The relationship between price and value holds the ultimate key to investment success.
Buying below value is the most dependable route to profit.

What causes an asset to sell below its value?
Primarily because perception understates reality.
It takes keen insight to detect cheapness.

The goal is to find good buys, not good assets.
Buying when the price is below value is a key element in limiting risk.

When other investors are unworried, we should be cautious.
When investors are panicked, we should turn aggressive.

Buying based on strong value, low price relative to value, and depressed general psychology is likely to provide the best results. Even then, things can go against us for a long time before turning as we think they should.

Related Book Summaries

Hope you enjoyed this and got value from my notes.
This is the 22nd book read in my 2020 reading list.
Here is a list of my book summaries.

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