The Most Important Thing

The Most Important Thing by Howard Marks offers you “uncommon sense for the thoughtful investor”. The book hopes to install an investment philosophy in you that will help you do well with your money.

I’ve started this book quite some years ago (say 2014) and am now re-reading it and making my notes here.

This book review is also part of my Financial Independence project/essay.

Introduction

  • “Successful investing requires thoughtful attention to many separate aspects, all at the same time.”
  • Essentially the introduction says to get information from a wide variety of sources
  • And that you learn best in hard times
  • Take action on what you’ve learned

The Most Important Thing Is … (chapter)

1. Second Level Thinking

  • No rule always works
  • Think one step beyond the obvious
    • If the stock is high, is it too high or maybe even still undervalued?

2. Understanding Market Efficiency (and Its Limitations)

  • The market reflects the consensus view/price
    • So only with an unconventional perspective, can you make (more) money
    • You are betting on inefficiencies in the market
  • The inefficiencies may only be there for a certain time

3. Value

  • Investment strategies can be based on fundamentals or price behaviour
    • The second sucks because there is a Random Walk
    • The historic price doesn’t predict the future price
  • Fundamentals can be divided into
    • Value investing (intrinsic value)
      • Current value is higher than the price
    • Growth investing (find companies that will grow fast in the future)
      • Company will outgrow current (correct) price
  • Growth investing is more difficult (more uncertainty)

4. The Relationship Between Price and Value

  • “If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value”
  • Psychology and technicals also change the price
    • The latter is things like forced selling during a crisis
    • The former constitutes group think, bias (e.g. earlier on alphabet)
  • “People should like something less when its price rises, but in investing they often like it more”
  • The routes to investment profits are:
    • Benefiting from a rise in the asset’s intrinsic value
    • Applying leverage (borrowing money, thus making/losing more)
    • Selling for more than your asset’s worth
    • Buying something for less than its value

5. Understanding Risk

  • Risk-adjusted return looks at the return you’ve made, in light of the risk (uncertainty, wider range of outcomes) that you took
  • The possibility of permanent loss is the worst risk
  • “There’s a big difference between probability and outcome. Probable things fail to happen – and improbable things happen – all the time”
  • Think of the Black Swan concept by Nassim Taleb (fat tail risks)
    • So protect yourself in case very bad things happen
  • We don’t fully ‘grog’ risk if we look back at the past (one outcome) as we try to predict the future (many outcomes possible)
  • We underestimate the biggest risk (e.g. global pandemic – written 24 March 2020)
  • Risk lumps together (sometimes many bad things happen at the same time for no reason)

6. Recognizing Risk

  • Risk increases during upswings, and materializes during recessions
  • “Risk tolerance is antithetical to successful investing”
  • If stocks are high, people believe the risk is gone (not true)
  • Investment risk is exactly there where it isn’t predicted/expected

7. Controlling Risk

  • Risk is not visible, only losses (when risk and negative events collide)
  • So if there are no losses, that doesn’t mean there wasn’t risk
  • Good portfolios have either lower risk or higher returns than average
  • Prepare for one-in-a-generation events (as you can’t prepare for everything)
  • (professional) investors are not in the market to make 4% (but more like 8%), so living without risk is not possible

8. Being Attentive to Cycles

  • There are always cycles (ups and downs)
  • Remember this rule and profit when others forget it
  • “The worst loans are made at the best of times” (because no one things there is risk – cycle turns around and ouch)
  • Just when people predict the market can never fall again, it probably will

9. Awareness of the Pendulum

  • The markets (and actors on the market) move like a pendulum, almost never being in the middle
  • E.g. between euphoria and depression, between overpriced and underpriced
  • The pendulum regarding risk attitudes is the most important one
  • The extreme attitude at one side of the pendulum will reverse

10. Combating Negative Influences

  • Human nature (psychology) often leads to making the wrong decisions
    • E.g. greed and optimism, or conversely fear
  • Another example is to conform to the view of the herd, rather than resist
  • So stick to intrinsic value (of a company)
  • Act out your plan (not based on your spur-of-the-moment feelings)
  • If things look ‘too good to be true’, they are
  • Be willing to look wrong when the market is misvalued
  • Find a support group / like-minded people

11. Contrarianism

  • “As the pendulum swings or the market goes through its cycles, the key to ultimate success lies in doing the opposite”
  • When the market is at an extreme (up or down), it reflects an inflection point (so be a contrarian)
  • “buy when they hate ’em, and sell when they love ’em”
  • It won’t be easy, you still need to have the ability to know when prices have diverged from their intrinsic value
    • Most of the time this won’t apply
    • And timing is everyting, overprices doesn’t equal going down now
  • So only do something contrarian, when you know the crowd is wrong

12. Finding Bargains

  1. buy best investments
  2. make room for them by selling lesser ones
  3. stay clear of the worst
  • You need rigour and discipline to find the bargains
  • e.g. bonds that were undervalued
  • Others need to (irrationally) think that this investment is not attractive (perception is worse than the ‘real’ situation)

13. Patient Opportunism

  • Wait for investments to come to you, don’t go searching for them (by changing your criteria)
  • Don’t ‘reach for returns’, to try and get a return when the market is not offering it (at your risk level)
  • Buy when others are forced to sell (in a crisis, they sell because they need to, not because the asset is bad)

14. Knowing What You Don’t Know

  • You can’t see the whole picture
    • only if you zoom in far enough can you say something with confidence
    • you might know where you are in a cycle/pendulum
  • Forecasts suck (they are bad, and thus of little value)
    • they just extrapolate the past
  • Overestimating what you know if the greatest vice

15. Having a Sense for When We Stand

  • You can’t know when the market turns, but you can know/estimate where on a cycle you are
    • Understand the present
    • What can you infer from that?

16. Appreciating the Role of Luck

  • Some improbable bets pay off, that doesn’t mean someone is skilled
  • Only in the long-term can you see who is really skilled
    • again the concept of alternative histories
  • It’s more important to survive a downturn, than to ‘win’ and be exposed to them (and lose in the long term)

17. Investing Defensively

  • Avoid losing, this is more important picking winners
  • Have a margin of safety/error
    • what if things go wrong, can you survive?
    • if you buy something at a low enough price, you have enough margin

18. Avoiding Pitfalls

  • “An investor needs do very few things right as long as he avoids big mistakes – Warren Buffet”
  • Sources of error are analytical or psychological/emotional
  • In the former, there is the ‘failure of imagination’, not being able to conceive of all possible scenarios
    • Again, the memory of the investor is short (and optimistic)
    • A crisis happens because improbably events collided with risk
    • Understanding correlation (or the lack of) between assets/portfolio is also important (all go up/down at same time)
  • The latter concerns many things already discussed (greed, mania)
  • Some tips on avoiding pitfalls:
    • take note of carefree, incautious behaviour of others
    • prepare psychologically for a downturn
    • sell risky assets
    • reduce leverage
    • raise cash (personal note: to buy when market is low again)
    • tilt portfolio towards increased defensiveness

19. Adding Value

  • beta: relative skill in relation to the market
  • alpha: personal investment skill (unrelated to movement of the market)
  • y = portfolio performance, y = a + βx
  • So look at both, and the risk (aggressive/defensive) profile of the investor
  • Oaktree (the investment firm the author is co-chair of) tries to do ok/average in good years, and do better (less bad) in bad years

20. Putting It All Together

  • Add value, by performing reliably and with skill
  • (the chapter summarizes all other chapters/lessons)
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