The Most Important Thing Illuminated

by Howard Marks

  In fiction, willing suspension of disbelief adds to our enjoyment. When we watch Peter Pan, we don’t want to hear the person sitting next to us say, “I can see the wires” (even though we know they’re there). While we know boys can’t fly, we don’t care; we’re just there for fun.

  But our purpose in investing is serious, not fun, and we must constantly be on the lookout for things that can’t work in real life. In short, the process of investing requires a strong dose of disbelief. … Inadequate skepticism contributes to investment losses. Time and time again, the postmortems of financial debacles include two classic phrases: “It was too good to be true” and “What were they thinking?”

  “HINDSIGHT FIRST, PLEASE (OR, WHAT WERE THEY THINKING?),” OCTOBER 17, 2005

  What makes investors fall for these delusions? The answer often lies in the ease with which—often in service to greed—they dismiss or ignore the lessons of the past. “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:

  When the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present. (John Kenneth Galbraith, A Short History of Financial Euphoria [New York: Viking, 1990])

  JOEL GREENBLATT: Many of the mistakes I have made are the same ones that I had made before; they just look a little different each time—the same mistake slightly disguised.

  The infallible investment that people come to believe can produce high returns without risk—the sure thing or free lunch—is well worth further discussion.

  When a market, an individual or an investment technique produces impressive returns for a while, it generally attracts excessive (and unquestioning) devotion. I call this solution du jour the “silver bullet.”

  Investors are always looking for it. Call it the holy grail or the free lunch, but everyone wants a ticket to riches without risk. Few people question whether it can exist or why it should be available to them. At the bottom line, hope springs eternal.

  But the silver bullet doesn’t exist. No strategy can produce high rates of return without risk. And nobody has all the answers; we’re all just human. Markets are highly dynamic, and, among other things, they function over time to take away the opportunity for unusual profits. Unskeptical belief that the silver bullet is at hand eventually leads to capital punishment.

  “THE REALIST’S CREED,” MAY 31, 2002

  What makes for belief in silver bullets? First, there’s usually a germ of truth.

  JOEL GREENBLATT: Remember, if theories (like rumors) didn’t have this germ of truth, no one would have believed them in the first place.

  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. As Warren Buffett told Congress on June 2, 2010, “Rising prices are a narcotic that affects the reasoning power up and down the line.” But after the fact—after it has popped—a mania is called a bubble.

  The fourth psychological contributor to investor error is the tendency to conform to the view of the herd rather than resist—even when the herd’s view is clearly cockeyed. In How Markets Fail, John Cassidy describes classic psychology experiments conducted by Swarthmore’s Solomon Asch in the 1950s. Asch asked groups of subjects to make judgments about visual exhibits, but all but one of the “subjects” in each group were shills working for him. The shills intentionally said the wrong thing, with dramatic impact on the one real subject. Cassidy explains, “This setup placed the genuine subject in an awkward spot: [As Asch put it,] ‘Upon him we have brought to bear two opposed forces: the evidence of his senses and the unanimous opinion of a group of his peers.’”

  A high percentage of the real subjects ignored what they saw and sided with the other group members, even though they were obviously in the wrong. This indicates the influence of the crowd and thus suggests reservations about the validity of consensus decisions.

  “Like the participants in Solomon Asch’s visual experiments in the 1950s,” Cassidy writes, “many people who don’t share the consensus view of the market start to feel left out. Eventually it reaches a stage where it appears the really crazy people are those not in the market.”

  Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense. It happens so regularly that there must be something dependable at work, not a random influence.

  The fifth psychological influence is envy. However negative the force of greed might be, always spurring people to strive for more and more, the impact is even stronger when they compare themselves to others. This is one of the most harmful aspects of what we call human nature.

  People who might be perfectly happy with their lot in isolation become miserable when they see others do better. In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.

  HOWARD MARKS: Emotion and ego: A lot of the drive in investing is competitive. High returns can be unsatisfying if others do better, while low returns are often enough if others do worse. The tendency to compare results is one of the most invidious. The emphasis on relative returns over absolute returns shows how psychology can distort the process.

  I know of a nonprofit institution whose endowment earned 16 percent a year from June 1994 to June 1999, but since its peers averaged 23 percent, the people involved with the endowment were dejected.

  SETH KLARMAN: Even the best investors judge themselves on the basis of return. It would be hard to evaluate yourself on risk, since risk cannot be measured. Apparently, the risk-averse managers of this endowment were disappointed with their relative returns even though their risk-adjusted performance was likely excellent, as borne out by their performance over the following three years. This highlights just how hard it is to maintain conviction over the long run when short-term performance is considered poor.

  Without growth stocks, technology stocks, buyouts and venture capital, the endowment was entirely out of step for half a decade. But then the tech stocks collapsed, and from June 2000 to June 2003 the institution earned 3 percent a year while most endowments suffered losses. The stakeholders were thrilled.

  There’s something wrong with this picture. How can people be unhappy making 16 percent a year and happy making 3 percent? The answer lies in the tendency to compare ourselves to others and the deleterious impact this can have on what should be a constructive, analytical process.

  JOEL GREENBLATT: This is incredibly important. Most institutional and individual investors benchmark their returns, and therefore most end up chasing the crowd: accent on the wrong sylLABle.

  The sixth key influence is ego. It can be enormously challenging to remain objective and calculating in the face of facts like these:

  • Investment results are evaluated and compared in the short run.

  • Incorrect, even imprudent, decisions to bear increased risk generally lead to the best returns in good times (and most times are good times).

  • The best returns bring the greatest ego rewards. When things go right, it’s fun to feel smart and have others agree.

  HOWARD MARKS: Emotion and ego: Investing—especially p
oor investing—is a world full of ego. Since risk bearing is rewarded in rising markets, ego can make investors behave aggressively in order to stand out through the achievement of lofty results. But the best investors I know seek stellar risk-adjusted returns … not celebrity. In my view, the road to investment success is usually marked by humility, not ego.

  In contrast, thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad. They avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check. This, in my opinion, is the greatest formula for long-term wealth creation—but it doesn’t provide much ego gratification in the short run. It’s just not that glamorous to follow a path that emphasizes humility, prudence and risk control. Of course, investing shouldn’t be about glamour, but often it is.

  Finally, I want to mention a phenomenon I call capitulation, a regular feature of investor behavior late in cycles. Investors hold to their convictions as long as they can, but when the economic and psychological pressures become irresistible, they surrender and jump on the bandwagon.

  In general, people who go into the investment business are intelligent, educated, informed and numerate. They master the nuances of business and economics and understand complex theories. Many are able to reach reasonable conclusions about value and prospects.

  But then psychology and crowd influences move in. Much of the time, assets are overpriced and appreciating further, or underpriced and still cheapening. Eventually these trends have a corrosive effect on investors’ psyches, conviction and resolve. The stocks you rejected are making money for others, the ones you chose to buy are lower every day, and concepts you dismissed as unsafe or unwise—hot new issues, high-priced tech stocks without earnings, highly levered mortgage derivatives—are described daily as delivering for others.

  As an overpriced stock goes even higher or an underpriced stock continues to cheapen, it should get easier to do the right thing: sell the former and buy the latter. But it doesn’t. The tendency toward self-doubt combines with news of other people’s successes to form a powerful force that makes investors do the wrong thing, and it gains additional strength as these trends go on longer. It’s one more influence that must be fought.

  HOWARD MARKS: Fear of looking wrong: Assets become overpriced because of investor behavior that overrates their merit and carries them aloft. This process shouldn’t be expected to come to a halt when the price has risen to the “right” level or when you’ve sold it because you feel it’s priced too high. Usually, the freight train rumbles on quite a bit further, and price judgments are much more likely to look wrong at first than right. Although understandable, this can be very hard to live with.

  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. This is especially true at the market extremes. The result is mistakes—frequent, widespread, recurring, expensive mistakes.

  HOWARD MARKS: Emotion and Ego: Most Swings toward the extreme of bubble and crazh are based on a seed of truth, usually subjected to reasonable analysis … at least at first. But psychological forces cause conclusions to incorporate error, and markets to go too far in incorporating those conclusions. The gravest market losses have their genesis in psychological errors, not analytical miscues.

  Does all this strike you as just so much theorizing, something that couldn’t possibly apply to you? I sincerely hope you’re right. But just in case you doubt that rational people could succumb to the damaging forces of emotion, let me remind you of two little words: tech bubble. Earlier I mentioned that crazy time as evidence of what happens when investors disregard the need for a reasonable relationship between value and price. What is it that causes them to abandon common sense? Some of the same emotions we have been talking about here: greed, fear, envy, self-deceit, ego. Let’s review the scenario and watch psychology at work.

  The 1990s were a very strong period for stocks. There were bad days and months, of course, and traumas such as a big jump in interest rates in 1994, but Standard & Poor’s 500 stock index showed a gain every year from 1991 through 1999 inclusive, and its return averaged 20.8 percent per year. Those results were enough to put investors in an optimistic mood and render them receptive to bullish stories.

  Growth stocks performed a bit better than value stocks in the early part of the decade—perhaps as a rebound from value’s outperformance in the 1980s. This, too, increased investors’ willingness to highly value companies’ growth potential.

  Investors became enthralled by technological innovation. Developments such as broadband, the Internet and e-commerce seemed likely to change the world, and tech and telecom entrepreneurs were lionized.

  Tech stocks appreciated, attracting more buying, and this led to further appreciation, in a process that as usual took on the appearance of an unstoppable virtuous circle.

  Logical-seeming rationales play a part in most bull markets, and this one was no different: tech stocks will outperform all other stocks because of the companies’ excellence. More tech names will be added to the equity indices, reflecting their growing importance in the economy. This will require index funds and the “closet indexers” who covertly emulate indices to buy more of them, and active investors will buy to keep up as well. More people will create 401(k) retirement plans, and 401(k) investors will increase the representation of stocks in their portfolios and the allocation to tech stocks among their stocks. For these reasons, tech stocks (a) must keep appreciating and (b) must outpace other stocks. Thus they’ll attract still more buying. The fact that all of these phenomena actually occurred for a while lent credence to this theory.

  Initial public offerings of technology stocks began to appreciate by tens and even hundreds of percent on the day of issue and took on the appearance of sure winners. Gaining access to IPOs became a popular mania.

  From the perspective of psychology, what was happening with IPOs is particularly fascinating. It went something like this: The guy next to you in the office tells you about an IPO he’s buying. You ask what the company does. He says he doesn’t know, but his broker told him it’s going to double on the day of issue. So you say that’s ridiculous. A week later he tells you it didn’t double … it tripled. And he still doesn’t know what it does. After a few more of these, it gets hard to resist. You know it doesn’t make sense, but you want protection against continuing to feel like an idiot. So, in a prime example of capitulation, you put in for a few hundred shares of the next IPO … and the bonfire grows still higher on the buying from new converts like you.

  Venture capital funds that had invested in successful start-up companies attracted great attention and a great deal of capital. In the year Google went public, the fund that had seeded it appreciated 350 percent on the basis of that one success.

  Tech stock investors were lauded by the media for their brilliance. The ones least restrained by experience and skepticism—and thus making the most money—were often in their thirties, even their twenties. Never was it pointed out that they might be beneficiaries of an irrational market rather than incredible astuteness.

  Remember my earlier comment that all bubbles start with a modicum of truth? The seed of truth for the scenario just described lay in technology’s very real potential. The fertilizer came from the attendant bullish rationales. And the supercharging came from the price appreciation that was taking place and looked unstoppable.

  Of course, the entire furor over technology, e-commerce and telecom stocks stems from the companies’ potential to change the world. I have absolutely no doubt that these movements are revolutionizing life as we know it, or that they will leave the world almost unrecognizable from what it was only a few years ago. The challenge lies in figuring out who the winners will be, and what a piece of them is really wor
th today. …

  To say technology, Internet and telecommunications are too high and about to decline is comparable today to standing in front of a freight train. To say they have benefited from a boom of colossal proportions and should be examined skeptically is something I feel I owe you.

  “BUBBLE.COM,” JANUARY 3, 2000

  Soon after the January 2000 memo was written, the tech stocks began to collapse of their own weight, even in the absence of any single event that would cause them to do so. All of a sudden it became clear that stock prices had gone too far and should correct. When an investment fad goes bad, The Wall Street Journal usually runs a table showing the resulting losses, with representative stocks down 90 percent or more. When the tech bubble burst, however, the table showed losses exceeding 99 percent. The broad stock indices experienced their first three-year decline since the Great Depression, and tech stocks—and stocks in general—no longer looked like anything special.

  When we look back over the intervening decade, we see that the vaunted technological developments did change the world, the winning companies are hugely valuable, and things like newspapers and CDs have been profoundly affected. But it’s equally obvious that investors allowed their common sense to be overridden in the bubble. They ignored the fact that not all the companies could win, that there would be a lengthy shake-out period, that profitability wouldn’t come easily from providing services gratis, and that shares in money-losing companies valued at high multiples of sales (since there were no earnings) carried great danger.