The Most Important Thing Illuminated

by Howard Marks

  • It’s also at these times that forecasts are least likely to be correct.

  • Some forecasters may turn out to be correct at these pivotal moments, suggesting that it’s possible to correctly forecast key events, but it’s unlikely to be the same people consistently.

  • The sum of this discussion suggests that, on balance, forecasts are of very little value.

  PAUL JOHNSON: These nine bullets offer the best discussion of the shortcomings of forecasting I have ever read.

  If you need proof, ask yourself how many forecasters correctly predicted the subprime problem, global credit crisis and massive meltdown of 2007–2008. You might be able to think of a few, and you might conclude that their forecasts were valuable. But then ask yourself how many of those few went on to correctly foresee the economic recovery that started slowly in 2009 and the massive market rebound that year. I think the answer’s “very few.”

  And that’s not an accident. Those who got 2007–2008 right probably did so at least in part because of a tendency toward negative views. As such, they probably stayed negative for 2009. The overall usefulness of those forecasts wasn’t great … even though they were partially right about some of the most momentous financial events in the last eighty years.

  So 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?” No one should bet much on the answer being affirmative.

  A prediction of global crisis in 2007–2008 would have had great potential value. But if you saw that it came from someone who wasn’t right consistently—and someone with a visible negative bias—would you have acted? That’s the trouble with inconsistent forecasters: not that they’re never right, but that the record isn’t positive enough to inspire action on their occasional brainstorms.

  It’s no secret that I have a limited opinion of forecasters and those who resolutely believe in them. In fact, I’ve come up with a label for these people.

  Most of the investors I’ve met over the years have belonged to the “I know” school. It’s easy to identify them.

  • They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success.

  • They’re confident it can be achieved.

  • They know they can do it.

  • They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.

  • They’re comfortable investing based on their opinions regarding the future.

  • They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.

  • They rarely look back to rigorously assess their record as forecasters.

  PAUL JOHNSON: Human beings are prone to want to make forecasts (it appears to be part of our natural wiring), and I suspect no amount of evidence is going to stop most from doing just that. However, Marks suggests that at the very least one should keep one’s own forecasting track record.

  Confident is the key word for describing members of this school. For the “I don’t know” school, on the other hand, the word—especially when dealing with the macro-future—is guarded. Its adherents generally believe you can’t know the future; you don’t have to know the future; and the proper goal is to do the best possible job of investing in the absence of that knowledge.

  As a member of the “I know” school, you get to opine on the future (and maybe have people take notes). You may be sought out for your opinions and considered a desirable dinner guest … especially when the stock market’s going up.

  Join the “I don’t know” school and the results are more mixed. You’ll soon tire of saying “I don’t know” to friends and strangers alike. After a while, even relatives will stop asking where you think the market’s going. You’ll never get to enjoy that one-in-a-thousand moment when your forecast comes true and the Wall Street Journal runs your picture. On the other hand, you’ll be spared all those times when forecasts miss the mark, as well as the losses that can result from investing based on overrated knowledge of the future.

  “US AND THEM,” MAY 7, 2004

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

  PAUL JOHNSON: Here, Marks offers the ultimate investing challenge and one of the key drivers of the desire to continue making forecasts.

  On the other hand, if it is, we’d better face up to it and find other ways to cope than through forecasts. Whatever limitations are imposed on us in the investment world, it’s a heck of a lot better to acknowledge them and accommodate than to deny them and forge ahead.

  Oh yes; one other thing: the biggest problems tend to arise when investors forget about the difference between probability and outcome—that is, when they forget about the 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.

  HOWARD MARKS: Understanding uncertainty: Risk and uncertainty aren’t the same as loss, but they create the potential for loss when things go wrong. Some of the biggest losses occur when overconfidence regarding predictive ability causes investors to underestimate the range of possibilities, the difficulty of predicting which one will materialize, and the consequences of a surprise.

  Imprudent investors who overlook these limitations tend to make mistakes in their portfolios and experience occasional large losses. That was the story of 2004–2007: because many people overestimated the extent to which outcomes were knowable and controllable, they underestimated the risk present in the things they were doing.

  The question of whether trying to predict the future will or will not work isn’t a matter of idle curiosity or academic musing. It has—or should have—significant ramifications for investor behavior. If you’re engaged in an activity that involves decisions with consequences in the future, it seems patently obvious that you’ll act one way if you think the future can be foreseen and a very different way if you think it can’t.

  One key question investors have to answer is whether they view the future as knowable or unknowable. Investors who feel they know what the future holds will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth—in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, 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.

  The first group of investors did much better in the years leading up to the crash. But the second group was better prepared when the crash unfolded, and they had more capital available (and more-intact psyches) with which to profit from purchases made at its nadir.

  “TOUCHSTONES,” NOVEMBER 10, 2009

  If you know the future, it’s silly to play defense. You should behave aggressively and target the greatest winners; there can be no loss to fear. Diversification is unnecessary, and maximum leverage can be employed. In fact, being unduly modest about what you know can result in opportunity costs (forgone profits).

  On the other hand, if you don’t know what the future holds, it’s foolhardy to act as if you do. Harkening back to Amos Tversky and the powerful quote that opened this chapter, the bottom line is clear. Investing in an unknowable future as an agnostic is a daunting prospect, but if foreknowledge
is elusive, investing as if you know what’s coming is close to nuts. Maybe Mark Twain put it best: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

  Overestimating what you’re capable of knowing or doing can be extremely dangerous—in brain surgery, transocean racing or investing. Acknowledging the boundaries of what you can know—and working within those limits rather than venturing beyond—can give you a great advantage.

  15

  The Most Important Thing Is … 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.

  Market cycles present the investor with a daunting challenge, given that:

  • Their ups and downs are inevitable.

  • They will profoundly influence our performance as investors.

  • They are unpredictable as to extent and, especially, timing.

  So we have to cope with a force that will have great impact but is largely unknowable. What, then, are we to do about cycles? The question is of vital importance, but the obvious answers—as so often—are not the right ones.

  The first possibility is that rather than accept that cycles are unpredictable, we should redouble our efforts to predict the future, throwing added resources into the battle and betting increasingly on our conclusions. But a great deal of data, and all my experience, tell me that the only thing we can predict about cycles is their inevitability. Further, superior results in investing come from knowing more than others, and it hasn’t been demonstrated to my satisfaction that a lot of people know more than the consensus about the timing and extent of future cycles.

  The second possibility is to accept that the future isn’t knowable, throw up our hands, and simply ignore cycles. Instead of trying to predict them, we could try to make good investments and hold them throughout. Since we can’t know when to hold more or less of them, or when our investment posture should become more aggressive or more defensive, we could simply invest with total disregard for cycles and their profound effect. This is the so-called buy-and-hold approach.

  There’s a third possibility, however, and in my opinion it’s the right one by a wide margin. Why not simply try to figure out where we stand in terms of each cycle and what that implies for our actions?

  In the world of investing, … nothing is as dependable as cycles. Fundamentals, psychology, prices and returns will rise and fall, presenting opportunities to make mistakes or to profit from the mistakes of others. They are the givens.

  We cannot know how far a trend will go, when it will turn, what will make it turn or how far things will then go in the opposite direction. But I’m confident that every trend will stop sooner or later. Nothing goes on forever.

  So what can we do about cycles? If we can’t know in advance how and when the turns will occur, how can we cope? On this, I am dogmatic: We may never know where we’re going, but we’d better have a good idea where we are. That is, even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.

  “IT IS WHAT IT IS,” MARCH 27, 2006

  PAUL JOHNSON: I respect Marks’s position on this issue. However, this goal is not nearly as simple as he suggests. He does offer a reasonable compromise in the memo below that I found very operational.

  It would be wonderful to be able to successfully predict the swings of the pendulum and always move in the appropriate direction, but this is certainly an unrealistic expectation. I consider it far more reasonable to try to (a) stay alert for occasions when a market has reached an extreme, (b) adjust our behavior in response and, (c) most important, refuse to fall into line with the herd behavior that renders so many investors dead wrong at tops and bottoms.

  “FIRST QUARTER PERFORMANCE,” APRIL 11, 1991

  I don’t mean to suggest that if we can figure out where we stand in a cycle we’ll know precisely what’s coming next. But I do think that understanding will give us valuable insight into future events and what we might do about them, and that’s all we can hope for.

  When I say that our present position (unlike the future) is knowable, I don’t mean to imply that understanding comes automatically. Like most things about investing, it takes work. But it can be done. Here are a few concepts I consider essential in that effort.

  First, we must be alert to what’s going on. The philosopher Santayana said, “Those who cannot remember the past are condemned to repeat it.” In very much the same way, I believe those who are unaware of what’s going on around them are destined to be buffeted by it.

  As difficult as it is know the future, it’s really not that hard to understand the present. What we need to do is “take the market’s temperature.” If we are alert and perceptive, we can gauge the behavior of those around us and from that judge what we should do.

  The essential ingredient here is inference, one of my favorite words. Everyone sees what happens each day, as reported in the media. But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what we should do in response?

  Simply put, we must strive to understand the implications of what’s going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into inaction or panic selling, we should become aggressive.

  So look around, and ask yourself: Are investors optimistic or pessimistic? Do the media talking heads say the markets should be piled into or avoided? Are novel investment schemes readily accepted or dismissed out of hand? Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls? Has the credit cycle rendered capital readily available or impossible to obtain? Are price/earnings ratios high or low in the context of history, and are yield spreads tight or generous?

  PAUL JOHNSON: These insightful questions can easily act as a checklist that investors could use periodically to take the market’s temperature.

  All of these things are important, and yet none of them entails forecasting. We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future.

  The key is to take note of things like these and let them tell you what to do. While the markets don’t cry out for action along these lines every day, they do at the extremes, when their pronouncements are highly important.

  The years 2007–2008 can be viewed as a painful time for markets and their participants, or as the greatest learning experience in our lifetimes. They were both, of course, but dwelling on the former isn’t of much help. Understanding the latter can make anyone a better investor. I can think of no better example than the devastating credit crisis to illustrate the importance of making accurate observations regarding the present and the folly of trying to forecast the future. It warrants a detailed discussion.

  It’s obvious in retrospect that the period leading up to the onset of the financial crisis in mid-2007 was one of unbridled—and unconscious—risk taking. With attitudes cool toward stocks and bonds, money flowed to “alternative investments” such as private equity—buyouts—in amounts sufficient to doom them to failure. There was unquestioning acceptance of the proposition that homes and other real estate would provide sure profits and cushion against inflation. And too-free access to capital with low interest rates and loose terms encouraged the use of leverage in amounts that proved excessive.

  After-the-fact risk awareness doesn’t do much good. The question is whether alertness and inference would have helped one avoid the full brunt of the 2007–2008 market declines. Here are some of the indicators of heatedness we saw:

  • The issuance of high yield bonds and below investment grade leveraged loans was at levels that constituted records by wide margins.

  • An unusually high percentage of the high yield bond issuance was
rated triple-C, a quality level at which new bonds usually can’t be sold in large amounts.

  • Issuance of debt to raise money for dividends to owners was routine. In normal times, such transactions, which increase the issuers’ riskiness and do nothing for creditors, are harder to accomplish.

  • Debt was increasingly issued with coupons that could be paid with more debt, and with few or no covenants to protect creditors.

  • Formerly rare triple-A debt ratings were assigned by the thousands to tranches of untested structured vehicles.

  • Buyouts were done at increasing multiples of cash flow and at increasing leverage ratios. On average, buyout firms paid 50 percent more for a dollar of cash flow in 2007 than they had in 2001.

  • There were buyouts of firms in highly cyclical industries such as semiconductor manufacturing. In more skeptical times, investors take a dim view of combining leverage and cyclicality.

  Taking all these things into consideration, a clear inference was possible: that providers of capital were competing to do so, easing terms and interest rates rather than demanding adequate protection and potential rewards. The seven scariest words in the world for the thoughtful investor—too much money chasing too few deals—provided an unusually apt description of market conditions.

  HOWARD MARKS: The riskiest things: When buyers compete to put large amounts of capital to work in a market, prices are bid up relative to value, prospective returns shrink, and risk rises. It’s only when buyers predominate relative to sellers that you can have highly overpriced assets. The warning signs shouldn’t be hard to spot.

  You can tell when too much money is competing to be deployed. The number of deals being done increases, as does the ease of doing deals; the cost of capital declines; and the price for the asset being bought rises with each successive transaction. A torrent of capital is what makes it all happen.