Book Summary: The Most Important Thing by Howard Marks

The Most Important Thing Book Review

Experience is what you got when you didn’t get what you wanted. This is true of life in general, but particularly relevant when it comes to the field of investing.

Successful investing requires thoughtful attention to many separate aspects, all at the same time. The Most Important Thing by Howard Marks covers these key aspects in layman language and without a lot of finance jargon though it covers the concepts of investment theory.

In the author’s words:

I have built this book around the idea of the most important things – each is a brick in what I hope will be a solid wall, and none is dispensable.
This book is a statement of my investment philosophy.

Howard Marks also recommends learning other greats in this field.

John Kenneth Galbraith on human foibles
Warren Buffett on patience and contrarianism
Charlie Munger on the importance of reasonable expectations
Bruce Newberg on ‘probability and outcome’
Michael Milken on conscious risk bearing
Ric Kayne on setting ‘traps’ (underrated investment opportunities where you can make a lot but can’t lose a lot).

Given my background in Finance I found certain sections too verbose, but it was refreshing to read up on investing after a long time and also read someone whose investment philosophy matches mine.

If you are new to investing, you would find this book an excellent introduction of the theory, practice and psychology in investing.

Must read if you are new to investing.

The Most Important Thing Book Summary

Note: This summary is made up of my notes, thoughts and highlights of important passages while reading the book. I keep updating the summary when I revisit it, and occasionally may edit it to reduce summary length. Don’t be surprised if it has changed between visits. The author’s words are in normal font, while my interpretations are in italics.

Second-Level Thinking

Everything should be made as simple as possible, but not simpler. ALBERT EINSTEIN

It’s not supposed to be easy. Anyone who finds it easy is stupid. CHARLIE MUNGER

Even the best investors don’t get it right every time. The reasons are simple. No rule always works.

Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable.

Because investing is at least as much art as it is science, it’s never my goal – in this book or elsewhere – to suggest it can be routinized.

One’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.

Just invest in an index fund that buys a little of everything. That will give you what is known as ‘market returns’.

Anyone can achieve average investment performance.

Definition of successful investing: doing better than the market and other investors.

Only a few of them will achieve the superior insight, intuition, sense of value and awareness of psychology that are required for consistently above-average results. Doing so requires second-level thinking.

Your goal in investing isn’t to earn average returns; you want to do better than average. Thus, 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 it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.’

First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’ Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic. Buy!’

First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority).

Second-level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account: What is the range of likely future outcomes? Which outcome do I think will occur? What’s the probability 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’s 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-level and second-level thinking is clearly massive.

First-level thinkers think the same way other first-level thinkers do about the same things.

All investors can’t beat the market since, collectively, they are the market.

To outperform the average investor, you have to be able to outthink the consensus. Are you capable of doing so? What makes you think so?

The problem is that extraordinary performance comes only from correct nonconsensus forecasts.

The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.

The good news is that the prevalence of first-level thinkers increases the returns available to second-level thinkers.

Understanding Market Efficiency (and Its Limitations)

In theory there’s no difference between theory and practice, but in practice there is. YOGI BERRA

Market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.

When I speak of this theory, I also use the word efficient, but I mean it in the sense of ‘speedy, quick to incorporate information,’ not ‘right.’

Asset prices immediately reflect the consensus view of the information’s significance. I do not, however, believe the consensus view is necessarily correct.

To beat the market you must hold an idiosyncratic, or nonconsensus, view.

The efficient market hypothesis is its conclusion that ‘you can’t beat the market.’

The greatest ramifications of the Chicago theory has been the development of passive investment vehicles known as index funds.

I have my own reservations about the theory, and the biggest one has to do with the way it links return and risk.

People are risk-averse by nature, meaning that in general they’d rather bear less risk than more.

Because theory says in an efficient market there’s no such thing as investing skill (commonly referred to today as alpha) that would enable someone to beat the market, all the difference in return between one investment and another – or between one person’s portfolio and another’s – is attributable to differences in risk.

If riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.

The key question is whether it’s right: Is the market unbeatable? Are the people who try wasting their time? Are the clients who pay fees to investment managers wasting their money?

Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both. They are on the alert for instances of misperception.

His first test is always the same: ‘And who doesn’t know that?’

Second-level thinkers depend on inefficiency.

Describing a market as inefficient is a high-flown way of saying the market is prone to mistakes that can be taken advantage of.

To me, an inefficient market is one that is marked by at least one (and probably, as a result, by all) of the following characteristics: Market prices are often wrong. Because access to information and the analysis thereof are highly imperfect, market prices are often far above or far below intrinsic values. The risk-adjusted return on one asset class can be far out of line with those of other asset classes. Because assets are often valued at other-than-fair prices, an asset class can deliver a risk-adjusted return that is significantly too high (a free lunch) or too low relative to other asset classes. Some investors can consistently outperform others. Because of the existence of (a) significant misvaluations and (b) differences among participants in terms of skill, insight and information access, it is possible for misvaluations to be identified and profited from with regularity.

Inefficient markets do not necessarily give their participants generous returns. Rather, it’s my view that they provide the raw material – mispricings – that can allow some people to win and others to lose on the basis of differential skill.

In the great debate over efficiency versus inefficiency, I have concluded that no market is completely one or the other. It’s just a matter of degree.

Efficiency is not so universal that we should give up on superior performance.

Efficiency is what lawyers call a ‘rebuttable presumption’ – something that should be presumed to be true until someone proves otherwise.

Bottom line: Inefficiency is a necessary condition for superior investing. Attempting to outperform in a perfectly efficient market is like flipping a fair coin: the best you can hope for is fifty-fifty. For investors to get an edge, there have to be inefficiencies in the underlying process – imperfections, mispricings – to take advantage of.

Because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.

Theory should inform our decisions but not dominate them.

Value

For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.

Buy at a price below intrinsic value, and sell at a higher price.

An investor has two basic choices: gauge the security’s underlying intrinsic value and buy or sell when the price diverges from it, or base decisions purely on expectations regarding future price movements.

Part of the decline of technical analysis can be attributed to the random walk hypothesis.

The random walk hypothesis says a stock’s past price movements are of absolutely no help in predicting future movements.

If something cannot go on forever, it will stop.

Day traders considered themselves successful if they bought a stock at $10 and sold at $11, bought it back the next week at $24 and sold at $25, and bought it a week later at $39 and sold at $40. If you can’t see the flaw in this – that the trader made $3 in a stock that appreciated by $30 – you probably shouldn’t read the rest of this book.

Two approaches, both driven by fundamentals: value investing and growth investing.

Value investors aim to come up with a security’s current intrinsic value and buy when the price is lower, and growth investors 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.

Adherence to value investing permits investors to avoid conjecture about the future and that growth investing consists only of conjecture about the future.

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

In my book, consistency trumps drama.

If value investing has the potential to consistently produce favorable results, does that mean it’s easy? No. For one thing, it depends on an accurate estimate of value. Without that, any hope for consistent success as an investor is just that: hope.

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.

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

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

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out.

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.

The Relationship Between Price and Value

Investment success doesn’t come from ‘buying good things,’ but rather from ‘buying things well.’

Deciding on an investment without carefully considering the fairness of its price is just as silly.

There’s no such thing as a good or bad idea regardless of price!

Well bought is half sold.

There’s nothing better than buying from someone who has to sell regardless of price during a crash.

You can’t make a career out of buying from forced sellers and selling to forced buyers.

Since buying from a forced seller is the best thing in our world, being a forced seller is the worst.

The key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship – and the outlook for it – lies largely in insight into other investors’ minds.

The discipline that is most important is not accounting or economics, but psychology.

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. Given time, its popularity, and thus its price, can only go one way: up.

In bubbles, ‘attractive’ morphs into ‘attractive at any price.’

In bubbles, infatuation with market momentum takes over from any notion of value and fair price.

Possible routes to investment profit:

Benefiting from a rise in the asset’s intrinsic value.
Applying leverage.
Selling for more than your asset’s worth.
Buying something for less than its value.

John Maynard Keynes pointed out, ‘The market can remain irrational longer than you can remain solvent.’

Trying to buy below value isn’t infallible, but it’s the best chance we have.

Understanding Risk

Risk means more things can happen than will happen. ELROY DIMSON

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

Dealing with risk is an essential – I think the essential – element in investing.

Why do I say risk assessment is such an essential element in the investment process?

First, risk is a bad thing, and most level-headed people want to avoid or minimize it.
Second, when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return.
Third, when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well. Was the return achieved in safe instruments or risky ones?

Capital market line that slopes upward to the right, indicating the positive relationship between risk and return.

If riskier investments reliably produced higher returns, they wouldn’t be riskier!

Riskier investments are those for which the outcome is less certain.

When priced fairly, riskier investments should entail: higher expected returns, the possibility of lower returns, and in some cases the possibility of losses.

Capital market theory, risk equals volatility, because volatility indicates the unreliability of an investment.

Theory says investors demand more return from investments that are more volatile.

Rather than volatility, I think people decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return.

Risk is – first and foremost – the likelihood of losing money.

The possibility of permanent loss is the risk I worry about.

Falling short of one’s goal
Underperformance
Career risk
Unconventionality
Risk that could jeopardize return to an agent’s firing point is rarely worth taking.
Illiquidity

First, risk of loss does not necessarily stem from weak fundamentals.

Second, risk can be present even without weakness in the macroenvironment.

How do they measure that risk?

First, it clearly is nothing but a matter of opinion: hopefully an educated, skillful estimate of the future, but still just an estimate.

Second, the standard for quantification is nonexistent.

Ben Graham and David Dodd put it this way more than sixty years ago in the second edition of Security Analysis, the bible of value investors: ‘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.’

Third, risk is deceptive.

Freakish, once-in-a-lifetime events are hard to quantify.

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

Because of its latent, nonquantitative and subjective nature, the risk of an investment – defined as the likelihood of loss – can’t be measured in retrospect any more than it can a priori.

The fact that something – in this case, loss – happened doesn’t mean it was bound to happen, and the fact that something didn’t happen doesn’t mean it was unlikely.

When markets are booming, the best results often go to those who take the most risk.

There’s a big difference between probability and outcome. Probable things fail to happen – and improbable things happen – all the time.

Mean or expected value (the outcome that on average is expected to occur), the median (the outcome with half the possibilities above and half below) or the mode (the single most likely outcome).

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.

The normal distribution assumes events in the distant tails will happen extremely infrequently, while the distribution of financial developments – shaped by humans, with their tendency to go to emotion-driven extremes of behavior – should probably be seen as having ‘fatter’ tails.

Quantification often lends excessive authority to statements that should be taken with a grain of salt.

Key to understanding risk: it’s largely a matter of opinion.

Many futures are possible, to paraphrase Dimson, but only one future occurs.

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

Risk cannot be measured. Certainly it cannot be gauged on the basis of what ‘everybody’ says at a moment in time.

Risk can be judged only by sophisticated, experienced second-level thinkers.

Investment risk is largely invisible before the fact – except perhaps to people with unusual insight – and even after an investment has been exited.

Risk exists only in the future, and it’s impossible to know for sure what the future holds.

Only the things that happened, happened.

My belief is that because the system is now more stable, we’ll make it less stable through more leverage, more risk taking. MYRON SCHOLES

Recognizing Risk

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

No matter how good fundamentals may be, humans exercising their greed and propensity to err have the ability to screw things up.

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

Recognizing risk often starts with understanding when investors are paying it too little heed, being too optimistic and paying too much for a given asset as a result.

High risk, in other words, comes primarily with high prices.

Participating when prices are high rather than shying away is the main source of risk.

The value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices.

When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so . . . and risk compensation will disappear.

Risk tolerance is antithetical to successful investing.

A prime element in risk creation is a belief that risk is low, perhaps even gone altogether.

Better safety gear can entice climbers to take more risk – making them in fact less safe.

Risk cannot be eliminated; it just gets transferred and spread.

Developments that make the world look less risky usually are illusory.

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

Why did they do these things? It all happened because investors believed too much, worried too little and thus took too much risk.

Worry and its relatives, distrust, skepticism and risk aversion, are essential ingredients in a safe financial system.

Only when investors are sufficiently risk-averse will markets offer adequate risk premiums.

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

Risk arises as investor behavior alters the market.

The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.

The market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior.

When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.

Controlling Risk

Outstanding investors, in my opinion, are distinguished at least as much for their ability to control risk as they are for generating return.

Great investors are those who take risks that are less than commensurate with the returns they earn.

Whatever few awards are presented for risk control, they’re never given out in good times.

Germs cause illness, but germs themselves are not illness. We might say illness is what results when germs take hold.

Loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.

The absence of loss does not necessarily mean the portfolio was safely constructed.

Risk may have been present even though loss didn’t occur.

The manager’s value added comes not through higher return at a given risk, but through reduced risk at a given return.

The intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.

So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events.

Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.

Will Rogers said, ‘You’ve got to go out on a limb sometimes because that’s where the fruit is.’

None of us is in this business to make 4 percent.

The road to long-term investment success runs through risk control more than through aggressiveness.

Being Attentive to Cycles

Nothing goes in one direction forever.

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.

The basic reason for the cyclicality in our world is the involvement of humans.

When people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

Everything that was good for the market yesterday is no good for it today.

The worst loans are made at the best of times.

Risk aversion is the essential ingredient in a rational market.

In crashes, on the other hand, investors fear too much.

The inevitable hallmark of bubbles is a dearth of risk aversion.

Finance theory is heavily dependent on the assumption that investors are risk-averse.

Reaping dependably high returns from risky investments is an oxymoron.

I’ve recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity.

Very early in my career, a veteran investor told me about the three stages of a bull market. Now I’ll share them with you.

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.

What the wise man does in the beginning, the fool does in the end.

At one extreme of the pendulum – the darkest of times – it takes analytical ability, objectivity, resolve, even imagination, to think things will ever get better. The few people who possess those qualities can make unusual profits with low risk.

The oscillation of the investor pendulum is very similar in nature to the up-and-down fluctuation of economic and market cycles.

Extreme market behavior will reverse.

Combating Negative Influences

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.

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.

Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions.

Many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently.

Many times over the course of my career, I’ve been amazed by how easy it is for people to engage in willing suspension of disbelief.

Demosthenes: ‘Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.’

The postmortems of financial debacles include two classic phrases: ‘It was too good to be true’ and ‘What were they thinking?’

Inadequate skepticism contributes to investment losses.

‘Extreme brevity of the financial memory,’ to use John Kenneth Galbraith’s wonderful phrase, keeps market participants from recognizing the recurring nature of these patterns, and thus their inevitability.

There can be few fields of human endeavor in which history counts for so little as in the world of finance.

Nobody has all the answers; we’re all just human.

No strategy can produce high rates of return without risk.

What makes for belief in silver bullets? First, there’s usually a germ of truth. It’s spun into an intelligent-sounding theory, and adherents get on their soapboxes to convince others. Then it produces profits for a while, whether because there’s merit in it or just because buying on the part of new converts lifts the price of the subject asset. Eventually, the appearance that (a) there’s a path to sure wealth and (b) it’s working turns it into a mania.

Warren Buffett told Congress on June 2, 2010, ‘Rising prices are a narcotic that affects the reasoning power up and down the line.’

To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored.

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

There’s only one way to describe most investors: trend followers. Superior investors are the exact opposite.

Superior investing, as I hope I’ve convinced you by now, requires second-level thinking.

Warren Buffett’s oft-quoted advice: ‘The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.’

Buy low; sell high is the time-honored dictum, but investors who are swept up in market cycles too often do just the opposite.

Once-in-a-lifetime market extremes seem to occur once every decade or so.

Most typical of market victims: the six-foot-tall man who drowned crossing the stream that was five feet deep on average.

Much of the time there aren’t great market excesses to bet against.

Contrarianism isn’t an approach that will make you money all of the time.

It can be extremely painful when the trend is going against you.

Markets can be over- or underpriced and stay that way – or become more so – for years.

It can appear at times that ‘everyone’ has reached the conclusion that the herd is wrong.

Contrarianism itself can appear to have become too popular, and thus contrarianism can be mistaken for herd behavior.

You must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong.

Casual commitments invite casual reversal.

Active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel.

The ultimately most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high).

What’s clear to the broad consensus of investors is almost always wrong.

The very coalescing of popular opinion behind an investment tends to eliminate its profit potential.

Most people seem to think outstanding performance to date presages outstanding future performance.

If everyone likes it, it’s likely the area has been mined too thoroughly.

Yogi Berra is famous for having said, ‘Nobody goes to that restaurant anymore; it’s too crowded.’

Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.

Successful investors are said to spend a lot of their time being lonely.

During the crisis, lots of bad things seemed possible, but that didn’t mean they were going to happen.

If you believe the story everyone else believes, you’ll do what they do.

Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t.

Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.

Skepticism and pessimism aren’t synonymous.

The key – as usual – was to become skeptical of what ‘everyone’ was saying and doing.

The error is clear. The herd applies optimism at the top and pessimism at the bottom.

To benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom.

Skepticism is usually thought to consist of saying, ‘no, that’s too good to be true’ at the right times.

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.

If we hold a view of value that enables us to buy when everyone else is selling – and if our view turns out to be right – that’s the route to the greatest rewards earned with the least risk.

The best opportunities are usually found among things most others won’t do.

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 (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.

The starting point for portfolio construction is unlikely to be an unbounded universe. Some things are realistic candidates for inclusion, and others aren’t.

Sid Cottle, editor of the later editions of Graham and Dodd’s Security Analysis, was talking about when he told me that in his view, ‘investment is the discipline of relative selection.’

Sid’s simple phrase embodies two important messages. First, the process of investing has to be rigorous and disciplined. Second, it is by necessity comparative.

Since we can’t change the market, if we want to participate, our only option is to select the best from the possibilities that exist. These are relative decisions.

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.

The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, get most investors into trouble.

Unlike assets that become the subject of manias, potential bargains usually display some objective defect.

Bargains are often created when investors either fail to consider an asset fairly, or fail to look beneath the surface to understand it thoroughly, or fail to overcome some non-value-based tradition, bias or stricture.

Unlike market darlings, the orphan asset is ignored or scorned.

Most investors extrapolate past performance, expecting the continuation of trends rather than the far-more-dependable regression to the mean.

A bargain asset tends to be one that’s highly unpopular.

Our goal is to find underpriced assets.

The necessary condition for the existence of bargains is that perception has to be considerably worse than reality.

Real men don’t buy converts, so chickens like me can buy cheap.

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.

Since bargains provide value at unreasonably low prices – and thus unusual ratios of return to risk – they represent the Holy Grail for investors.

It’s obvious that investors can be forced into mistakes by psychological weakness, analytical error or refusal to tread on uncertain ground. Those mistakes create bargains for second-level thinkers capable of seeing the errors of others.

Patient Opportunism

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.

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

An opportunist buys things because they’re offered at bargain prices. There’s nothing special about buying when prices aren’t low.

We don’t look for our investments; they find us.

If we call the owner and say, ‘You own X and we want to buy it,’ the price will go up. But if the owner calls us and says, ‘We’re stuck with X and we’re looking for an exit,’ the price will go down.

At any particular point in time, the investment environment is a given, and we have no alternative other than to accept it and invest within it.

It’s essential for investment success that we recognize the condition of the market and decide on our actions accordingly.

We must invest appropriately for the circumstances with which we’re presented.

Mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Thus we must recognize, accept, cope and respond. Isn’t that the essence of investing?

What’s past is past and can’t be undone.

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.

The dumbest thing you can do is to insist on perpetuating high returns – and give back your profits in the process.

You simply cannot create investment opportunities when they’re not there.

If it’s not there, hoping won’t make it so. Wishing won’t make it so.

You want to take risk when others are fleeing from it, not when they’re competing with you to do so.

To wring high returns from a low-return environment requires the ability to swim against the tide and find the relatively few winners.

The real goal of active investment management is to buy things for less than they’re worth.

The key during a crisis is to be (a) insulated from the forces that require selling and (b) positioned to be a buyer instead.

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

Knowing What You Don’t Know

We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know. JOHN KENNETH GALBRAITH

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

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

Awareness of the limited extent of our foreknowledge is an essential component of my approach to investing.

The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage.

Know the knowable.

Predictions are most useful when they correctly anticipate change.

If you predict that something won’t change and it doesn’t change, that prediction is unlikely to earn you much money.

Most of the forecasts consisted of extrapolations.

Like many forecasters, these economists were driving with their eyes firmly fixed on the rearview mirror, enabling them to tell us where things were but not where they were going.

It’s difficult to make accurate predictions, especially with regard to the future.

Predicting the past is a snap.

Investment results will be determined entirely by what happens in the future.

Most of the time, people predict a future that is a lot like the recent past.

Most of the time the future largely is a rerun of the recent past.

Just as forecasters usually assume a future that’s a lot like the past, so do markets, which usually price in a continuation of recent history.

The key question isn’t ‘are forecasters sometimes right?’ but rather ‘are forecasts as a whole – or any one person’s forecasts – consistently actionable and valuable?’

For the ‘I don’t know’ school, on the other hand, the word – especially when dealing with the macro-future – is guarded.

No one likes having to invest for the future under the assumption that the future is largely unknowable.

The biggest problems tend to arise when investors forget about the difference between probability and outcome.

Limits on foreknowledge: when they believe the shape of the probability distribution is knowable with certainty (and that they know it), when they assume the most likely outcome is the one that will happen, when they assume the expected result accurately represents the actual result, or perhaps most important, when they ignore the possibility of improbable outcomes.

Investors who feel they know what the future holds will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth.

Those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.

If you know the future, it’s silly to play defense.

Being unduly modest about what you know can result in opportunity costs (forgone profits).

If you don’t know what the future holds, it’s foolhardy to act as if you do.

Overestimating what you’re capable of knowing or doing can be extremely dangerous.

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

Having a Sense for Where We Stand

We may never know where we’re going, but we’d better have a good idea where we are.

The only thing we can predict about cycles is their inevitability.

Every trend will stop sooner or later. Nothing goes on forever.

The philosopher Santayana said, ‘Those who cannot remember the past are condemned to repeat it.’

We must strive to understand the implications of what’s going on around us.

We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future.

There’s simply no magic in investing.

Appreciating the Role of Luck

Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill.

The truth is, much in investing is ruled by luck. Some may prefer to call it chance or randomness, and those words do sound more sophisticated than luck.

A great deal of the success of everything we do as investors will be heavily influenced by the roll of the dice.

Clearly my way of judging matters is probabilistic in nature; it relies on the notion of what could have probably happened.

In boom times, the highest returns often go to those who take the most risk. That doesn’t say anything about their being the best investors.

Randomness contributes to (or wrecks) investment records to a degree that few people appreciate fully. As a result, the dangers that lurk in thus-far-successful strategies often are underrated.

When things go right, luck looks like skill. Coincidence looks like causality. A ‘lucky idiot’ looks like a skilled investor.

Investors are right (and wrong) all the time for the ‘wrong reason.’

The correctness of a decision can’t be judged from the outcome.

A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown.

Randomness alone can produce just about any outcome in the short run.

It’s essential to have a large number of observations – lots of years of data – before judging a given manager’s ability.

Things that happened are only a small subset of the things that could have happened. Thus, the fact that a stratagem or action worked – under the circumstances that unfolded – doesn’t necessarily prove the decision behind it was wise.

The ability of chance occurrences to reward unwise decisions and penalize good ones.

A good decision is one that a logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known.

It can be hard to know who made the best decision. On the other hand, past returns are easily assessed, making it easy to know who made the most profitable decision. It’s easy to confuse the two, but insightful investors must be highly conscious of the difference.

In the long run, there’s no reasonable alternative to believing that good decisions will lead to investment profits. In the short run, however, we must be stoic when they don’t.

Short-term gains and short-term losses are potential impostors, as neither is necessarily indicative of real investment ability (or the lack thereof).

The actions of the ‘I know’ school are based on a view of a single future that is knowable and conquerable.

‘I don’t know’ school thinks of future events in terms of a probability distribution.

We should spend our time trying to find value among the knowable – industries, companies and securities – rather than base our decisions on what we expect from the less-knowable macro world of economies and broad market performance.

We have to practice defensive investing, since many of the outcomes are likely to go against us.

It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.

For those who view the world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly; insistence on defensive investing; and emphasis on avoiding pitfalls. To me that’s what thoughtful investing is all about.

Investing Defensively

There are old investors, and there are bold investors, but there are no old bold investors.

When friends ask me for personal investment advice, my first step is to try to understand their attitude toward risk and return.

Which do you care about more, making money or avoiding losses?’

You can’t simultaneously go all out for both profit making and loss avoidance. Each investor has to take a position regarding these two goals, and usually that requires striking a reasonable balance.

Professional tennis is a ‘winner’s game,’ in which the match goes to the player who’s able to hit the most winners: fast-paced, well-placed shots that an opponent can’t return.

The tennis the rest of us play is a ‘loser’s game,’ with the match going to the player who hits the fewest losers. The winner just keeps the ball in play until the loser hits it into the net or off the court.

In amateur tennis, points aren’t won; they’re lost.

Investors should commit to an approach – hopefully one that will serve them through a variety of scenarios.

In good times, we feel it’s okay if we just keep up with the indices (and in the best of times we may even lag a bit).

Oaktree portfolios are set up to outperform in bad times, and that’s when we think outperformance is essential.

What is offense in investing, and what is defense? Offense is easy to define. It’s the adoption of aggressive tactics and elevated risk in the pursuit of above-average gains. But what’s defense? Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.

Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses,

There are two principal elements in investment defense. The first is the exclusion of losers from portfolios.

The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes.

Concentration (the opposite of diversification) and leverage are two examples of offense. They’ll add to returns when they work but prove harmful when they don’t.

Defense, on the other hand, can increase your likelihood of being able to get through the tough times and survive long enough to enjoy the eventual payoff from smart investments.

Investors must brace for untoward developments.

What is it that makes outcomes tolerable even when the future doesn’t live up to your expectations? The answer is margin for error.

The choice is simple: try to maximize returns through aggressive tactics, or build in protection through margin for error. You can’t have both in full measure.

Of the two ways to perform as an investor – racking up exceptional gains and avoiding losses – I believe the latter is the more dependable.

A conscious balance must be struck between striving for return and limiting risk – between offense and defense.

In fixed income, where I got my start as a portfolio manager, returns are limited and the manager’s greatest contribution comes through the avoidance of loss.

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.

In equities and other more upside-oriented areas, avoiding losses isn’t enough; potential for return must be present as well.

I don’t think many investment managers’ careers end because they fail to hit home runs. Rather, they end up out of the game because they strike out too often – not because they don’t have enough winners, but because they have too many losers.

If we avoid the losers, the winners will take care of themselves.’

The cautious seldom err or write great poetry.

Caution can help us avoid mistakes, but it can also keep us from great accomplishments.

Defensive investing sounds very erudite, but I can simplify it: Invest scared! Worry about the possibility of loss.

Avoiding Pitfalls

An investor needs do very few things right as long as he avoids big mistakes. WARREN BUFFETT

sources of error as being primarily analytical/intellectual or psychological/emotional.

failure of imagination.’ By that I mean either being unable to conceive of the full range of possible outcomes or not fully understanding the consequences of the more extreme occurrences.

Failure of imagination – the inability to understand in advance the full breadth of the range of outcomes.

Investing consists entirely of dealing with the future.

Few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third.

Failure of imagination consists in the first instance of not anticipating the possible extremeness of future events, and in the second instance of failing to understand the knock-on consequences of extreme events.

Psychological forces are some of the most interesting sources of investment error.

Investors’ occasional willingness to accept the novel rationales that underlie bubbles and crashes, usually out of a belief that ‘it’s different this time.’

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.

Think about what ‘today’s mistake’ might be and try to avoid it.

When there’s nothing particularly clever to do, the potential pitfall lies in insisting on being clever.

Adding Value

The performance of investors who add value is asymmetrical. The percentage of the market’s gain they capture is higher than the percentage of loss they suffer. Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek.

Two terms from investment theory.

One is beta, a measure of a portfolio’s relative sensitivity to market movements.
The other is alpha, which I define as personal investment skill, or the ability to generate performance that is unrelated to movement of the market.

A passive index fund will produce just that result by holding every security in a given market index in proportion to its equity capitalization.

The risk that markets compensate for is the risk that is intrinsic and inescapable in investing: systematic or ‘non-diversifiable’ risk.

A manager who earned 18 percent with a risky portfolio isn’t necessarily superior to one who earned 15 percent with a lower-risk portfolio. Risk-adjusted return holds the key,

‘Beating the market’ and ‘superior investing’ can be far from synonymous.

It’s not just your return that matters, but also what risk you took to get it.

it’s our goal to do as well as the market when it does well and better than the market when it does poorly.

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

Pulling It All Together

To oversimplify, there’s cash on the books and the value of the tangible assets; the ability of the company or asset to generate cash; and the potential for these things to increase.

To achieve superior investment results, your insight into value has to be superior.

Buying below value is the most dependable route to profit. Paying above value rarely works out as well.

Outstanding buying opportunities exist primarily because perception understates reality.

The goal is to find good buys, not good assets.

The relationship between price and value is influenced by psychology and technicals.

The psychology of the investing herd moves in a regular, pendulum-like pattern – from optimism to pessimism.

Risk aversion – an appropriate amount of which is the essential ingredient in a rational market.

What the wise man does in the beginning, the fool does in the end.

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

Not even contrarianism, however, will produce profits all the time. The great opportunities to buy and sell are associated with valuation extremes, and by definition they don’t occur every day.

Things can go against us for a long time before turning as we think they should. Underpriced is far from synonymous with going up soon.

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

Most investors think diversification consists of holding many different things; few understand that diversification is effective only if portfolio holdings can be counted on to respond differently to a given development in the environment.

If we avoid the losers, the winners will take care of themselves.

A diversified portfolio of investments, each of which is unlikely to produce significant loss, is a good start toward investment success.

The defensive investor places a heavy emphasis on not doing the wrong thing. Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in good times,

It takes margin for error to render outcomes tolerable when the future doesn’t oblige.

Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average.’

It’s only in the bad years – when the tide goes out – that the value of defense becomes evident.

The investor’s time is better spent trying to gain a knowledge advantage regarding ‘the knowable’: industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don’t.

Investing on the basis of strongly held but incorrect forecasts is a source of significant potential loss.

The most successful investors get things ‘about right’ most of the time, and that’s much better than the rest.

Only investors with unusual insight can regularly divine the probability distribution that governs future events and sense when the potential returns compensate for the risks that lurk in the distribution’s negative left-hand tail. This simple description of the requirements for successful investing – based on understanding the range of possible gains and the risk of untoward developments – captures the elements that should receive your attention.

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