by Howard Marks
• between euphoria and depression,
• between celebrating positive developments and obsessing over negatives, and thus
• between overpriced and underpriced.
This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.”
“FIRST QUARTER PERFORMANCE,” APRIL 11, 1991
Thirteen years later I revisited the subject of the pendulum at length in another memo. In it I observed that in addition to the elements mentioned earlier, the pendulum also swings with regard to greed versus fear; willingness to view things through an optimistic or a pessimistic lens; faith in developments that are on-the-come; credulousness versus skepticism; and risk tolerance versus risk aversion.
The swing in the last of these—attitudes toward risk—is a common thread that runs through many of the market’s fluctuations.
Risk aversion is the essential ingredient in a rational market, as I said before, and the position of the pendulum with regard to it is particularly important. Improper amounts of risk aversion are key contributors to the market excesses of bubble and crash. It’s an oversimplification—but not a grievous one—to say the inevitable hallmark of bubbles is a dearth of risk aversion. In crashes, on the other hand, investors fear too much. Excessive risk aversion keeps them from buying even when no optimism—only pessimism—is embodied in prices and valuations are absurdly low.
In my opinion, the greed/fear cycle is caused by changing attitudes toward risk. When greed is prevalent, it means investors feel a high level of comfort with risk and the idea of bearing it in the interest of profit. Conversely, widespread fear indicates a high level of aversion to risk. The academics consider investors’ attitude toward risk a constant, but certainly it fluctuates greatly.
Finance theory is heavily dependent on the assumption that investors are risk-averse. That is, they “disprefer” risk and must be induced—bribed—to bear it, with higher expected returns.
Reaping dependably high returns from risky investments is an oxymoron. But there are times when this caveat is ignored—when people get too comfortable with risk and thus when prices of securities incorporate a premium for bearing risk that is inadequate to compensate for the risk that’s present. …
PAUL JOHNSON: Marks links risk and security prices/valuation directly, something that is not done in general finance theory but is exceedingly important for investors to understand.
When investors in general are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-averse, prices can offer more return than risk.
“THE HAPPY MEDIUM,” JULY 21, 2004
The pendulum swing regarding attitudes toward risk is one of the most powerful of all. In fact, I’ve recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both. In an ideal world, investors would balance these two concerns. But from time to time, at the extremes of the pendulum’s swing, one or the other predominates. For example:
• In 2005, 2006 and early 2007, with things going so swimmingly and the capital markets wide open, few people imagined that losses could lie ahead. Many believed risk had been banished. Their only worry was that they might miss an opportunity; if Wall Street came out with a new financial miracle and other investors bought and they didn’t—and if the miracle worked—they might look unprogressive and lose ground. Since they weren’t concerned about losing money, they didn’t insist on low purchase prices, adequate risk premiums or investor protection. In short, they behaved too aggressively.
• Then in late 2007 and 2008, with the credit crisis in full flower, people began to fear a complete meltdown of the world financial system. No one worried about missing opportunity; the pendulum had swung to the point where people worried only about losing money. Thus, they ran from anything with a scintilla of risk—regardless of the potential return—and to the safety of government securities with yields near zero. At this point, then, investors feared too much, sold too eagerly and positioned their portfolios too defensively.
SETH KLARMAN: Paul Isaac has called this “return-free risk.”
PAUL JOHNSON: These two bullets provide an excellent recap of the many mistakes investors made in the years leading up to the 2008 financial crisis.
Thus, the last several years have provided an unusually clear opportunity to witness the swing of the pendulum … and how consistently most people do the wrong thing at the wrong time. 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. And it will ever be so.
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
Why would anyone waste time trying for a better description? This one says it all. It’s essential that we grasp its significance.
The market has a mind of its own, and it’s changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves like a pendulum.
Stocks are cheapest when everything looks grim.
PAUL JOHNSON: This short comment furthers Marks’s point about the financial crisis. These few words capture the challenges of successful investing. It is hard for the average investor to commit capital to a new investment when the outlook is gloomy. Yet it is precisely in these moments that potential returns are at their highest.
The depressing outlook keeps them there, and only a few astute and daring bargain hunters are willing to take new positions. Maybe their buying attracts some attention, or maybe the outlook turns a little less depressing, but for one reason or another, the market starts moving up.
After a while, the outlook seems a little less poor. People begin to appreciate that improvement is taking place, and it requires less imagination to be a buyer. Of course, with the economy and market off the critical list, they pay prices that are more reflective of stocks’ fair values.
And eventually, giddiness sets in. Cheered by the improvement in economic and corporate results, people become willing to extrapolate it. The masses become excited (and envious) about the profits made by investors who were early, and they want in. And they ignore the cyclical nature of things and conclude that the gains will go on forever. That’s why I love the old adage “What the wise man does in the beginning, the fool does in the end.” Most important, in the late stages of the great bull markets, people become willing to pay prices for stocks that assume the good times will go on ad infinitum.
“YOU CAN’T PREDICT. YOU CAN PREPARE,” NOVEMBER 20, 2001
HOWARD MARKS: The riskiest things: The ultimate danger zone is reached when investors are in agreement that things can only get better forever. That makes no sense, but most people fall for it. It’s what creates bubbles—just as the opposite produces crashes.
Thirty-five years after I first learned about the stages of a bull market, after the weaknesses of subprime mortgages (and their holders) had been exposed and as people were worrying about contagion to a global crisis, I came up with the flip side, the three stages of a bear market:
• The first, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy
• The second, when most investors recognize things are deteriorating
• The third, when everyone’s convinced things can only get worse
One of these days, though, we’ll reach the third stage, and the herd will give up on there being a solution. And unless the financial world really does end, we’re likely to encounter the investment opportunities of a lifetime. Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.
“THE TIDE GOES OUT,” MARCH 18, 2008
Just six months after those words were written, the progression had gone all the way to the third stage. A full meltdown of the world financial system was considered possible; in fact, the first steps—the bankruptcy of Lehman Brothers and the absorption or rescue of Bear Stearns, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, Wachovia and WaMu—had taken place. Since this was the biggest crisis ever, investors bought into the third stage, during which “everyone’s convinced things can only get worse,” more than ever before. Thus, in many asset classes, the things determined by the pendulum’s swing—the price declines in 2008, the resultant investment opportunities at the nadir, and the gains in 2009—were the greatest I’ve ever seen.
The significance of all this is the opportunity it offers to those who recognize what is happening and see the implications. 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. But at the other extreme, when everyone assumes and prices in the impossible—improvement forever—the stage is set for painful losses.
It all goes together. None of these is an isolated event or a chance occurrence. Rather, they’re all elements in a recurring pattern that can be understood and profited from.
The oscillation of the investor pendulum is very similar in nature to the up-and-down fluctuation of economic and market cycles described in chapter 8. For some reason I find myself making a distinction between the two and speaking of them in different terms, but they’re both highly important, and the key lessons are the same. With the benefit of almost twenty years’ experience since writing that first memo about the pendulum in 1991, I’ll rephrase its key observations:
• In theory with regard to polarities such as fear and greed, the pendulum should reside mostly at a midpoint between the extremes. But it doesn’t for long.
JOEL GREENBLATT: This means markets will always create opportunities, whether now or later. In markets with few opportunities, it’s important to be patient. Value opportunities will eventually present themselves, usually after no more than a year or two.
• Primarily because of the workings of investor psychology, it’s usually swinging toward or back from one extreme or the other.
• The pendulum cannot continue to swing toward an extreme, or reside at an extreme, forever (although when it’s positioned at its greatest extreme, people increasingly describe that as having become a permanent condition).
• Like a pendulum, the swing of investor psychology toward an extreme causes energy to build up that eventually will contribute to the swing back in the other direction. Sometimes, the pent-up energy is itself the cause of the swing back—that is, the pendulum’s swing toward an extreme corrects of its very weight.
• The swing back from the extreme is usually more rapid—and thus takes much less time—than the swing to the extreme. (Or as my partner Sheldon Stone likes to say, “The air goes out of the balloon much faster than it went in.”)
The occurrence of this pendulum-like pattern in most market phenomena is extremely dependable. But just like the oscillation of cycles, we never know:
• how far the pendulum will swing in its arc,
• what might cause the swing to stop and turn back,
• when this reversal will occur, or
• how far it will then swing in the opposite direction.
For a bullish phase … to hold sway, the environment has to be characterized by greed, optimism, exuberance, confidence, credulity, daring, risk tolerance and aggressiveness. But these traits will not govern a market forever. Eventually they will give way to fear, pessimism, prudence, uncertainty, skepticism, caution, risk aversion and reticence. … Busts are the product of booms, and I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction.
“NOW WHAT?” JANUARY 10, 2008
There are a few things of which we can be sure, and this is one: Extreme market behavior will reverse. Those who believe that the pendulum will move in one direction forever—or reside at an extreme forever—eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously.
10
The Most Important Thing Is … 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. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, widespread and recurring.
PAUL JOHNSON: This is an excellent description of the emotional pressure most investors feel when confronted with the power of a bull market—and as Marks points out, few of us are immune to these forces.
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. To distinguish yourself from the others, you need to be on the right side of those mistakes.
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.
CHRISTOPHER DAVIS: And not only their psyches and emotions—perverse incentives can influence institutional investors’ decision making in negative ways.
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. To say this another way, 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. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological. Investor psychology includes many separate elements, which we will look at in this chapter, but the key thing to remember is that they consistently lead to incorrect decisions. Much of this falls under the heading of “human nature.”
HOWARD MARKS: Emotion and ego: Psychological influences have great power over investors. Most succumb, permitting investor psychology to determine the swings of the market. When those forces push markets to extremes of bubble or crash, they create opportunities for superior investors to augment their results by refusing to hold at the highs and by insisting on buying at the lows. Resisting the inimical forces is an absolute requirement.
The first emotion that serves to undermine investors’ efforts is the desire for money, especially as it morphs into greed.
Most people invest to make money. (Some participate as an intellectual exercise or because it’s a good field in which to vent their competitiveness, but even they keep score in terms of money. Money may not be everyone’s goal for its own sake, but it is everyone’s unit of account. People who don’t care about money generally don’t go into investing.)
There’s nothing wrong with trying to make money. Indeed, the desire for gain is one of the most important elements in the workings of the market and the overall economy. The danger comes when it moves on further to greed, which Merriam-Webster’s defines as an “inordinate or all-consuming and usually r
eprehensible acquisitiveness especially for wealth or gain.”
Greed is an extremely powerful force. It’s strong enough to overcome common sense, risk aversion, prudence, caution, logic, memory of painful past lessons, resolve, trepidation and all the other elements that might otherwise keep investors out of trouble. Instead, from time to time greed drives investors to throw in their lot with the crowd in pursuit of profit, and eventually they pay the price.
The combination of greed and optimism repeatedly leads people to pursue strategies they hope will produce high returns without high risk; pay elevated prices for securities that are in vogue; and hold things after they have become highly priced in the hope there’s still some appreciation left. Afterwards, hindsight shows everyone what went wrong: that expectations were unrealistic and risks were ignored.
“HINDSIGHT FIRST, PLEASE (OR, WHAT WERE THEY THINKING?),” OCTOBER 17, 2005
The counterpart of greed is fear—the second psychological factor we must consider. In the investment world the term doesn’t mean logical, sensible risk aversion. Rather, fear—like greed—connotes excess. Fear, then, is more like panic. Fear is overdone concern that prevents investors from taking constructive action when they should.
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. Thus, the third factor I want to discuss is people’s tendency to dismiss logic, history and time-honored norms. This tendency makes people accept unlikely propositions that have the potential to make them rich … if only they held water. Charlie Munger gave me a great quotation on this subject, from Demosthenes: “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” The belief that some fundamental limiter is no longer valid—and thus historic notions of fair value no longer matter—is invariably at the core of every bubble and consequent crash.
