The Most Important Thing Illuminated

by Howard Marks

  If you make cars and want to sell more of them over the long term—that is, take permanent market share from your competitors—you’ll try to make your product better. … That’s why—one way or the other—most sales pitches say, “Ours is better.” However, there are products that can’t be differentiated, and economists call them “commodities.” They’re goods where no seller’s offering is much different from any other. They tend to trade on price alone, and each buyer is likely to take the offering at the lowest delivered price. Thus, if you deal in a commodity and want to sell more of it, there’s generally one way to do so: cut your price. …

  It helps to think of money as a commodity just like those others. Everyone’s money is pretty much the same. Yet institutions seeking to add to loan volume, and private equity funds and hedge funds seeking to increase their fees, all want to move more of it. So if you want to place more money—that is, get people to go to you instead of your competitors for their financing—you have to make your money cheaper.

  One way to lower the price for your money is by reducing the interest rate you charge on loans. A slightly more subtle way is to agree to a higher price for the thing you’re buying, such as by paying a higher price/earnings ratio for a common stock or a higher total transaction price when you’re buying a company. Any way you slice it, you’re settling for a lower prospective return.

  “THE RACE TO THE BOTTOM,” FEBRUARY 17, 2007

  One trend investors might have observed during this dangerous period, had they been alert, was the movement along the spectrum that runs from skepticism to credulousness in regard to what I described earlier as the silver bullet or can’t-lose investment. Thoughtful investors might have noticed that the appetite for silver bullets was running high, meaning greed had won out over fear and signifying a nonskeptical—and thus risky—market.

  Hedge funds came to be viewed as just such a sure thing during the last decade, and especially those called “absolute return” funds. These were long/short or arbitrage funds that wouldn’t pursue high returns by making “directional” bets on the market’s trend. Rather, the managers’ skill or technology would enable them to produce consistent returns in the range of 8 to 11 percent regardless of which way the market went.

  Too few people recognized that achieving rock-steady returns in that range would be a phenomenal accomplishment—perhaps too good to be true. (N.B.: that’s exactly what Bernard Madoff purported to be earning.) Too few wondered (a) how many managers there are with enough talent to produce that miracle, especially after the deduction of substantial management and incentive fees, (b) how much money they could do it with and (c) how their highly levered bets on small statistical discrepancies would fare in a hostile environment. (In the difficult year of 2008, the term absolute return was shown to have been overused and misused, as the average fund lost about 18 percent.)

  As described at length in chapter 6, we heard at the time that risk had been eliminated through the newly popular wonders of securitization, tranching, selling onward, disintermediation and decoupling. Tranching deserves particular attention here. It consists of allocating a portfolio’s value and cash flow to stakeholders in various tiers of seniority. The owners of the top-tier claim get paid first; thus, they enjoy the greatest safety and settle for relatively low returns. Those with bottom-tier claims are in the “first-loss” position, and in exchange for accepting heightened risk they enjoy the potential for high returns from the residual that’s left over after the fixed claims of the senior tranches have been paid off.

  In the years 2004–2007, the notion arose that if you cut risk into small pieces and sell the pieces off to investors best suited to hold them, the risk disappears. Sounds like magic. Thus, it’s no coincidence that the tranched securitizations from which so much was expected became the site of many of the worst meltdowns: there’s simply no magic in investing.

  Absolute return funds, low-cost leverage, riskless real estate investments and tranched debt vehicles were all the rage. Of course, the error in all these things became clear beginning in August 2007. It turned out that risk hadn’t been banished and, in fact, had been elevated by investors’ excessive trust and insufficient skepticism.

  The period from 2004 through the middle of 2007 presented investors with one of the greatest opportunities to outperform by reducing their risk, if only they were perceptive enough to recognize what was going on and confident enough to act. All you really had to do was take the market’s temperature during an overheated period and deplane as it continued upward. Those who were able to do so exemplify the principles of contrarianism, discussed in chapter 11. Contrarian investors who had cut their risk and otherwise prepared during the lead-up to the crisis lost less in the 2008 meltdown and were best positioned to take advantage of the vast bargains it created.

  There are few fields in which decisions as to strategies and tactics aren’t influenced by what we see in the environment. Our pressure on the gas pedal varies depending on whether the road is empty or crowded. The golfer’s choice of club depends on the wind. Our decision regarding outerwear certainly varies with the weather. Shouldn’t our investment actions be equally affected by the investing climate?

  Most people strive to adjust their portfolios based on what they think lies ahead. At the same time, however, most people would admit forward visibility just isn’t that great. That’s why I make the case for responding to the current realities and their implications, as opposed to expecting the future to be made clear.

  “IT IS WHAT IT IS,” MARCH 27, 2006

  THE POOR MAN’S GUIDE TO MARKET ASSESSMENT

  Here’s a simple exercise that might help you take the temperature of future markets. I have listed a number of market characteristics. For each pair, check off the one you think is most descriptive of today. And if you find that most of your checkmarks are in the left-hand column, as I do, hold on to your wallet.

  “IT IS WHAT IT IS,” MARCH 27, 2006

  CHRISTOPHER DAVIS: This table might be even more useful if it would allow for scaling—i.e., use a 1 to 5 scale for each category and allow “N/As” where necessary. With that modification, this is a great guide.

  JOEL GREENBLATT: A wonderful chart and a great exercise.

  PAUL JOHNSON: I feel strongly that running through this checklist twice a year would allow an investor to keep tabs on the swing of the market’s pendulum. After a decade, the investor would have a rich database of past market swings from which to draw. I wish I had started such a list ten years ago.

  Markets move cyclically, rising and falling. The pendulum oscillates, rarely pausing at the “happy medium,” the midpoint of its arc. Is this a source of danger or of opportunity? And what are investors to do about it? My response is simple: try to figure out what’s going on around us, and use that to guide our actions.

  16

  The Most Important Thing Is … Appreciating the Role of Luck

  Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill.

  The investment world is not an orderly and logical place where the future can be predicted and specific actions always produce specific results. The truth is, much in investing is ruled by luck. Some may prefer to call it chance or randomness, and those words do sound more sophisticated than luck. But it comes down to the same thing: a great deal of the success of everything we do as investors will be heavily influenced by the roll of the dice.

  PAUL JOHNSON: For me the theme of this chapter is: Learn to be honest with yourself about your successes and failures. Learn to recognize the role luck has played in all outcomes. Learn to decide which outcomes came about because of skill and which because of luck. Until one learns to identify the true source of success, one will be fooled by randomness.

  To fully explore the notion of luck, in this chapter I want to advance some ideas expressed by Nassim Nicholas Taleb in hi
s book Fooled by Randomness. Some of the concepts I explore here occurred to me before I read it, but Taleb’s book put it all together for me and added more. I consider it one of the most important books an investor can read.

  PAUL JOHNSON: I, too, am a huge fan of Nassim Taleb’s work, much of which Marks draws on for this chapter. I am particularly fond of Taleb’s concept of alternative histories, and Marks does an excellent job of incorporating this concept into his investment philosophy.

  I borrowed some of Taleb’s ideas for a 2002 memo titled “Returns and How They Get That Way,” which incorporated excerpts from Fooled by Randomness, represented here by italics.

  Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not.

  Thus, when considering whether an investment record is likely to be repeated, it is essential to think about the role of randomness in the manager’s results, and whether the performance resulted from skill or simply being lucky.

  $10 million earned through Russian roulette does not have the same value as $10 million earned through the diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one’s dependence on randomness is greater than the other. To your accountant, though, they would be identical. … Yet, deep down, I cannot help but consider them as qualitatively different.

  Every record should be considered in light of the other outcomes—Taleb calls them “alternative histories”—that could have occurred just as easily as the “visible histories” that did.

  Clearly my way of judging matters is probabilistic in nature; it relies on the notion of what could have probably happened. …

  If we have heard of [history’s great generals and inventors], it is simply because they took considerable risks, along with thousands of others, and happened to win. They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day—but so did thousands of others who live in the musty footnotes of history.

  Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill.

  Think about the aggressive backgammon player who can’t win without a roll of double sixes, with its probability of happening once in every thirty-six rolls of the dice. The player accepts the cube—doubling the stakes—and then gets his boxcars. It might have been an unwise bet, but because it succeeded, everybody considers the player brilliant. We should think about how probable it was that something other than double sixes would materialize, and thus how lucky the player was to have won. This says a lot about the player’s likelihood of winning again. …

  In the short run, a great deal of investment success can result from just being in the right place at the right time. I always say the keys to profit are aggressiveness, timing and skill, and someone who has enough aggressiveness at the right time doesn’t need much skill.

  At a given time in the markets, the most profitable traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists—because of the nature of randomness.

  The easy way to see this is that in boom times, the highest returns often go to those who take the most risk. That doesn’t say anything about their being the best investors.

  Warren Buffett’s appendix to the fourth revised edition of The Intelligent Investor describes a contest in which each of the 225 million Americans starts with $1 and flips a coin once a day. The people who get it right on day one collect a dollar from those who were wrong and go on to flip again on day two, and so forth. Ten days later, 220,000 people have called it right ten times in a row and won $1,000. “They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.” After another ten days, we’re down to 215 survivors who’ve been right 20 times in a row and have each won $1 million. They write books titled like How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning and sell tickets to seminars. Sound familiar?

  Thus, randomness contributes to (or wrecks) investment records to a degree that few people appreciate fully. As a result, the dangers that lurk in thus-far-successful strategies often are underrated.

  Perhaps a good way to sum up Taleb’s views is by excerpting from a table in his book. He lists in the first column a number of things that easily can be mistaken for the things in the second column.

  Luck Skill

  Randomness Determinism

  Probability Certainty

  Belief, conjecture Knowledge, certitude

  Theory Reality

  Anecdote, coincidence Causality, law

  Survivorship bias Market outperformance

  Lucky idiot Skilled investor

  I think this dichotomization is sheer brilliance. We all know that when things go right, luck looks like skill. Coincidence looks like causality. A “lucky idiot” looks like a skilled investor. Of course, knowing that randomness can have this effect doesn’t make it easy to distinguish between lucky investors and skillful investors.

  SETH KLARMAN: This is why it is all-important to look not at investors’ track records but at what they are doing to achieve those records. Does it make sense? Does it appear replicable? Why haven’t competitive forces priced away any apparent market inefficiencies that enabled this investment success?

  But we must keep trying.

  I find that I agree with essentially all of Taleb’s important points.

  • Investors are right (and wrong) all the time for the “wrong reason.” Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway; the investor looks good (and invariably accepts credit).

  • The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa.

  • Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof). But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly).

  • For these reasons, investors often receive credit they don’t deserve. One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone. Few of these “geniuses” are right more than once or twice in a row.

  • Thus, it’s essential to have a large number of observations—lots of years of data—before judging a given manager’s ability.

  “RETURNS AND HOW THEY GET THAT WAY,” NOVEMBER 11, 2002

  Taleb’s idea of “alternative histories”—the other things that reasonably could have happened—is a fascinating concept, and one that is particularly relevant to investing.

  Most people acknowledge the uncertainty that surrounds the future, but they feel that at least the past is known and fixed. After all, the past is history, absolute and unchanging. But Taleb points out that the things that happened are only a small subset of the things that could have happened. Thus, the fact that a stratagem or action worked—under the circumstances that unfolded—doesn’t necessarily prove the decision behind it was wise.

  Maybe what ultimately made the decision a success was a completely unlikely event, something that was just a matter of luck. In that case that decision—as successful as it turned out to be—may have been unwise, and the many other histories that could have happened would have shown the error of the decision.

  How much credit should a decision maker receive for having bet on a highly uncertain outcome that unfolded luc
kily? This is a good question, and it deserves to be looked at in depth.

  One of the first things I remember learning after entering Wharton in 1963 was that the quality of a decision is not determined by the outcome. The events that transpire afterward make decisions successful or unsuccessful, and those events are often well beyond anticipating. This idea was powerfully reinforced when I read Taleb’s book. He highlights the ability of chance occurrences to reward unwise decisions and penalize good ones.

  What is a good decision? Let’s say someone decides to build a ski resort in Miami, and three months later a freak blizzard hits south Florida, dumping twelve feet of snow. In its first season, the ski area turns a hefty profit. Does that mean building it was a good decision? No.

  A good decision is one that a logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known. By that standard, the Miami ski resort looks like folly.

  As with risk of loss, many things that will bear on the correctness of a decision cannot be known or quantified in advance. Even after the fact, it can be hard to be sure who made a good decision based on solid analysis but was penalized by a freak occurrence, and who benefited from taking a flier. Thus, it can be hard to know who made the best decision. On the other hand, past returns are easily assessed, making it easy to know who made the most profitable decision. It’s easy to confuse the two, but insightful investors must be highly conscious of the difference.