The Most Important Thing – Something for the Thoughtful Investor

The Most Important Thing: Uncommon Sense for the Thoughtful Investor, by Howard Marks, distills decades of knowledge and experience into an engaging book that conveys his investment philosophy as a collection of indispensable principles.

According to Marks, the most important thing(s) include:

1. Learn to Practice 2nd Level Thinking

Few people have what it takes to be great investors…
The reason is simple. No rule always works.
The environment isn’t controllable
and circumstances rarely repeat exactly.

Successful investors see the forest and the trees. They understand that investing is both an art and a science. Savvy investors adapt and look past the surface to consider a variety of possible outcomes. They consider probabilities and act in unconventional ways that reject popular opinion.

2. Assess Value

Every investment approach can be divided into two overarching categories: those that analyze a company’s characteristics (fundamentals) and those that track stock price patterns (technicals).

Investors attempt to buy low and sell high. Doing this, on a regular basis, requires determining what makes some stocks and companies more valuable than others.

One crucial question to ask yourself is – valuable when?

Value investors primarily focus on buying securities whose present value is higher than their present price.

Growth investors primarily focus on buying securities when they feel the company’s value, and the value of its stock, will increase over time.

Determining value is complex and difficult, but accurately assessing it is the only way to ensure you won’t overpay.

…if you overpay, it takes a surprising improvement in value,
a strong market or an even less discriminating buyer
(what we used to call a “greater fool”) to bail you out.

Value investors must be prepared to hang on to securities, post purchase, because time (sometimes long periods of time) is what generally brings market price back into alignment with value. Put another way, profit comes from the accurate assessment of the underlying value of a security, the realization that the price does not reflect the underlying value, and the willingness to wait until it does.

3. Risk is Inevitable, Learn to Navigate It

Because risk is an inherent, inevitable aspect of investing, successful investors must learn to avoid, manage, and minimize it. This topic was significant enough that Marks dedicated three chapters to it.

According to Marks, every investment decision should take into consideration whether the potential return is sufficient to warrant the amount of risk. Riskier investments typically involve less dependable outcomes, and therefore a greater probability of loss.

Risk can be defined in many ways and appears in a variety of forms including, failing to reach one’s financial goals, underperforming stocks, and illiquidity (being unable to quickly or easily sell an investment to convert it to cash).

Risk, like underlying value, is complex and difficult to assess. Investors are prone to overestimating their ability to notice and evaluate risk, which is largely invisible at any particular moment. Often, they are only fully aware of the realities of risk in hindsight, during market downturns, or when they’re taking large losses.

Risk becomes more prevalent as bull markets near their peak, when overzealous optimism drives prices unsustainably high. In other words, as the majority is less aware of and concerned about risk, it’s increasing.

At these times, the fear of loss is replaced with the fear of missing out. On the other hand, risk is typically lowest when the consensus is that it’s higher.

…the herd is wrong about risk at least
as often as it is about return.
A broad consensus that something’s
too hot to handle is almost always wrong.
Usually, it’s the opposite that’s true.

Mitigating risk sets the best investors apart from the rest. While others engage in risk management during tough times, savvy investors manage risk all of time. They’re able to consistently achieve high returns while bearing low levels of risk.

Some of the tactics successful investors use include being realistic when others are overly optimistic or pessimistic, diversification, thorough analysis, and not attempting to predict the future (particularly the near future).

Marks points out that, over time, a skillful investor’s superior portfolio performance is the result of having fewer losses more so than the stellar gains of any individual investment.

4. Seeing and Assessing Cycles

Although only one chapter of this book addressed cycles, Marks takes a deeper dive in a follow-up book, titled Mastering the Market Cycle: Getting the Odds on Your Side.

Marks doesn’t feel that attempting to predict what’s coming is useful. He does feel that you can (and should) prepare for the range of probable possibilities. Much of his wisdom about this topic is summed up as:

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 current stages of a cycle are often the primary cause of the next. There are entire market cycles, sector cycles (ex: financials, real estate, etc.), and business cycles (credit, debt, etc.). Some are shorter, others longer, a few exceed the length of a human lifespan. There are cycles within others, as well as those that overlap, run parallel, or are concurrent.

Successful investors don’t believe those who claim what’s currently happening is new, unique, or different. To the contrary, they’re aware of and tracking cycles.

Savvy investors also disregard those who believe a trend will continue indefinitely. Rather, they’ll take these sentiments as a sign there’s a shift approaching.

5. Watch for the Pendulum Swings

As cycles go round and round, the pendulum swings up and down. Marks uses this analogy to describe the ways the market moves in response to investor sentiment. Prices are driven down as investors become pessimistic, fearful, and risk averse. They climb again, as investors become optimistic, greedy, and overconfident.

With each swing, the pendulum shoots past the middle, which is more representative of the present underlying value. Because at the extremes of the pendulum swings securities are overvalued or undervalued, there will always be another correction, a pull back to center.

From Mark’s perspective, this ongoing trend is caused by investors doing the opposite of what they ought to.

When things are going well and prices are high,
investors rush to buy, forgetting all prudence.
Then, when there’s chaos all around
and assets are on the bargain counter,
they lose all willingness to bear risk and rush to sell.

Investors’ emotions, biases, and sentiment have a greater impact on stock prices, in the short term, than intrinsic value. The market tends to swing higher more gradually and swing lower more abruptly.

Just as is true for cycles, because someone can know a trend will reverse but likely won’t know exactly when it will happen, preparation is far more useful than prediction.

6. Develop a Contrarian Mindset

Most investors go with the flow, but to produce above average returns one must move against the current. Contrarian investors buck trends, not caring what is currently popular. They move in ways that differ from the crowd.

It isn’t difficult to understand the value of contrarianism in theory. Because the peaks at both ends of a market swing result from greater sentiment consensus, as a trend’s popularity increases, it’s less likely to continue. Actually acting on this knowledge, walking away as excitement is spreading like wildfire and hype has become highly contagious, can be extremely difficult.

Even when we understand why being contrarian is the most important thing, it’s easy to second guess and doubt oneself when acting alone.

Contrarians don’t simply do the opposite of others. It’s not that simple. It is important to have evidence to the contrary, to understand where and why the crowd is mistaken.

Sometimes the majority believes they’re on the road less traveled when that is, of course, a statistical impossibility. Put another way, “hot” stocks by definition aren’t selling at low prices.

Sure, it’s possible for something to move
from “overvalued” to “more overvalued,”
but I wouldn’t count on it happening.

Savvy investors think and analyze for themselves. They look for opportunities to buy what has become undervalued and sell what has become overvalued.

Contrarianism allows investors to take advantage of today’s over and underpriced assets in order to generate higher than average returns over time.

Marks draws an important distinction between being skeptical and pessimistic. He points out that skeptics question both the positive and the negative, especially when everyone is sure it’s true. They understand that knives can’t fall forever and bubbles will burst.

7. Be Patient

Marks points out that sometimes the best thing to do is nothing. The market doesn’t present wonderful opportunities every day. But, it does reliably present wonderful opportunities for those who are willing to wait. He points out that not selecting a security is superior to selecting the wrong security.

Many investors actively seek out, or reach for, returns. The problem is, as they’re busy chasing, they fail to understand that they’re risking more and more for less and less.

Successful investors realize that they can’t wish for opportunities, or force them. What they can do is be prepared to act swiftly as they arise.

An investor needs the following things:
staunch reliance on value, little or no use of leverage,
long-term capital and a strong stomach.

Marks discusses potential strategies for unfavorable market conditions. One option is to hold more cash, which is difficult for those who feel their money should stay busy making more money. Another tactic is specialization, looking for an area that holds more potential than the broader market. But, as Marks points out, this becomes difficult with larger portfolios.

The best opportunities are created when others have no choice but to sell securities at substandard prices. Those investors who manage to avoid the conditions that pressure others to sell can position themselves to be a buyer in those transactions.

8. A Strong Defense is the Best Offense

Marks references “The Loser’s Game”, an article by Charles Ellis, published in The Financial Analysts Journal in 1975. It contrasted professional and amateur tennis. While professionals consistently hit the ball where they want, at the speed they want, amateurs make plenty of mistakes.

Rather than matches going to the players who hit more outstanding shots, amateur matches go to the players who hit fewer lousy shots. This analogy reminds me of a holiday pool tournament where the winning team was the only one that didn’t scratch on the 8-ball.

Unlike tennis pros, the best investors cannot precisely predict where, or when, the “ball” will land. There are simply too many variables beyond their control. Rather than acting aggressively to “go for the win” it is better to take safer shots, to keep the ball in play. Marks points out that the strategies used to avoid losses are more reliable than those used to achieve gains.

Over a full career, most investors’ results will be
determined more by how many losers they have,
and how bad they are, then by the greatness of their winners.
Skillful risk control is the mark of the superior investor”.

According to Marks, the essential element in defensive investing is the insistence on a “margin of safety”, the amount a stock’s price falls below its underlying value. This safety net paves the way for a “margin of error”, having acceptable outcomes even when those things beyond one’s control don’t play out in favorable ways.

This does not mean the best investors are solely focused on loss avoidance and controlling risk. What it does mean is that they find a place of balance between offensive and defensive tactics.