by Howard Marks
HOWARD MARKS: Fear of looking wrong: It’s counterintuitive but extremely important: given the randomness and variability at work in our environment, it’s often true that good decisions fail to work and bad decisions succeed. In particular, investors are “right for the wrong reason” (and vice versa) all the time. You mustn’t let this frustrate you and convince you your good decisions were mistakes (unless so many prove wrong that you have to consider that possibility).
In the long run, there’s no reasonable alternative to believing that good decisions will lead to investment profits. In the short run, however, we must be stoic when they don’t.
PAUL JOHNSON: I love this observation. Oh so very true
Since the investors of the “I know” school, described in chapter 14, feel it’s possible to know the future, they decide what it will look like, build portfolios designed to maximize returns under that one scenario, and largely disregard the other possibilities. The suboptimizers of the “I don’t know” school, on the other hand, put their emphasis on constructing portfolios that will do well in the scenarios they consider likely and not too poorly in the rest.
Investors who belong to the “I know” school predict how the dice will come up, attribute their successes to their astute sense of the future, and blame bad luck when things don’t go their way. When they’re right, the question that has to be asked is “Could they really have seen the future or couldn’t they?” Because their approach is probabilistic, investors of the “I don’t know” school understand that the outcome is largely up to the gods, and thus that the credit or blame accorded the investors—especially in the short run—should be appropriately limited.
The “I know” school quickly and confidently divides its members into winners and losers based on the first roll or two of the dice. Investors of the “I don’t know” school understand that their skill should be judged over a large number of rolls, not just one (and that rolls can be few and far between). Thus they accept that their cautious, suboptimzing approach may produce undistinguished results for a while, but they’re confident that if they’re superior investors, that will be apparent in the long run.
Short-term gains and short-term losses are potential impostors, as neither is necessarily indicative of real investment ability (or the lack thereof).
PAUL JOHNSON: This is a great line. How many investors have fallen for this mistake?
Surprisingly good returns are often just the flip side of surprisingly bad returns. One year with a great return can overstate the manager’s skill and obscure the risk he or she took. Yet people are surprised when that great year is followed by a terrible year. Investors invariably lose track of the fact that both short-term gains and short-term losses can be impostors, and of the importance of digging deep to understand what underlies them.
Investment performance is what happens to a portfolio when events unfold. People pay great heed to the resulting performance, but the questions they should ask are, Were the events that unfolded (and the other possibilities that didn’t unfold) truly within the ken of the portfolio manager? And what would the performance have been if other events had occurred instead? Those other events are Taleb’s “alternative histories.”
“PIGWEED,” DECEMBER 7, 2006
JOEL GREENBLATT: The best-performing mutual fund for the decade of the 2000s made 18 percent per year. The average (dollar-weighted) investor in the fund lost 8 percent per year during this same period. Investment inflows followed “up” performance, or outperformance and outflows followed losses or underperformance. Apparently, there was little long-term assessment of investment skill by most investors when making allocation decisions.
I find Taleb’s ideas novel and provocative. Once you realize the vast extent to which randomness can affect investment outcomes, you look at everything in a very different light.
The actions of the “I know” school are based on a view of a single future that is knowable and conquerable. My “I don’t know” school thinks of future events in terms of a probability distribution. That’s a big difference. In the latter case, we may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.
HOWARD MARKS: Understanding uncertainty: People who think the future is knowable (and that they can know it) belong to what I call the “I know” school. They ignore the presence of uncertainty and act in ways that will increase profits if they’re right but expose them to increased losses if they’re wrong. Recognizing this, it’s important for all investors to figure out whether they know and act accordingly.
Clearly, Taleb’s view of an uncertain world is much more consistent with mine. Everything I believe and recommend about investing proceeds from that school of thought.
• We should spend our time trying to find value among the knowable—industries, companies and securities—rather than base our decisions on what we expect from the less-knowable macro world of economies and broad market performance.
• Given that we don’t know exactly which future will obtain, we have to get value on our side by having a strongly held, analytically derived opinion of it and buying for less when opportunities to do so present themselves.
• We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.
• To improve our chances of success, we have to emphasize acting contrary to the herd when it’s at extremes, being aggressive when the market is low and cautious when it’s high.
• Given the highly indeterminate nature of outcomes, we must view strategies and their results—both good and bad—with suspicion until proved out over a large number of trials.
CHRISTOPHER DAVIS: This is a very good summary.
Several things go together for those who view the world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly; insistence on defensive investing; and emphasis on avoiding pitfalls.
JOEL GREENBLATT: For good investors, as the time horizon expands, which allows skill to come into play, the probability distribution of long-term returns should narrow.
To me that’s what thoughtful investing is all about.
17
The Most Important Thing Is … Investing Defensively
There are old investors, and there are bold investors, but there are no old bold investors.
JOEL GREENBLATT: This saying works double for old pilots and bold pilots.
When friends ask me for personal investment advice, my first step is to try to understand their attitude toward risk and return. Asking for investment advice without specifying that is like asking a doctor for a good medicine without telling him or her what ails you.
So I ask, “Which do you care about more, making money or avoiding losses?” The answer is invariably the same: both.
The problem is that you can’t simultaneously go all out for both profit making and loss avoidance. Each investor has to take a position regarding these two goals, and usually that requires striking a reasonable balance. The decision should be made consciously and rationally. This chapter’s about the choice … and my recommendation.
The best way to put this decision into perspective is by thinking of it in terms of offense versus defense. And one of the best ways to consider this is through the metaphor of sports.
To establish the groundwork for this discussion, I’ll refer to the wonderful article by Charles Ellis, titled “The Loser’s Game,” that appeared in The Financial Analysts Journal in 1975. This may have been my first exposure to a direct analogy between investing and sports, and it was absolutely seminal regarding my emphasis on defensive investing.
Charley’s article
described the perceptive analysis of tennis contained in Extraordinary Tennis for the Ordinary Tennis Player by Dr. Simon Ramo, the “R” in TRW, once a conglomerate with products ranging from auto parts to credit reporting services. Ramo pointed out that professional tennis is a “winner’s game,” in which the match goes to the player who’s able to hit the most winners: fast-paced, well-placed shots that an opponent can’t return.
Given anything other than an outright winner by an opponent, professional tennis players can make the shot they want almost all the time: hard or soft, deep or short, left or right, flat or with spin. Professional players aren’t troubled by the things that make the game challenging for amateurs: bad bounces; wind; sun in the eyes; limitations on speed, stamina and skill; or an opponent’s efforts to put the ball beyond reach. The pros can get to most shots their opponents hit and do what they want with the ball almost all the time. In fact, pros can do this so consistently that tennis statisticians keep track of the relatively rare exceptions under the heading “unforced errors.”
But the tennis the rest of us play is a “loser’s game,” with the match going to the player who hits the fewest losers. The winner just keeps the ball in play until the loser hits it into the net or off the court. In other words, in amateur tennis, points aren’t won; they’re lost. I recognized in Ramo’s loss-avoidance strategy the version of tennis I try to play.
Charley Ellis took Ramo’s idea a step further, applying it to investments. His views on market efficiency and the high cost of trading led him to conclude that the pursuit of winners in the mainstream stock markets is unlikely to pay off for the investor. Instead, you should try to avoid hitting losers. I found this view of investing absolutely compelling.
The choice between offense and defense investing should be based on how much the investor believes is within his or her control. In my view, investing entails a lot that isn’t.
Professional tennis players can be quite sure that if they do A, B, C and D with their feet, body, arms and racquet, the ball will do E just about every time; there are relatively few random variables at work. But investing is full of bad bounces and unanticipated developments, and the dimensions of the court and the height of the net change all the time. The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment. Even if you do everything right, other investors can ignore your favorite stock; management can squander the company’s opportunities; government can change the rules; or nature can serve up a catastrophe.
So much is within the control of professional tennis players that they really should go for winners. And they’d better, since if they serve up easy balls, their opponents will hit winners of their own and take points. In contrast, investment results are only partly within the investors’ control, and investors can make good money—and outlast their opponents—without trying tough shots.
The bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match. Thus, defense—significant emphasis on keeping things from going wrong—is an important part of every great investor’s game.
There are a lot of things I like about investing, and most of them are true of sports as well.
• It’s competitive—some succeed and some fail, and the distinction is clear.
• It’s quantitative—you can see the results in black and white.
• It’s a meritocracy—in the long term, the better returns go to the superior investors.
• It’s team oriented—an effective group can accomplish more than one person.
• It’s satisfying and enjoyable—but much more so when you win.
These positives can make investing a very rewarding activity in which to engage. But as in sports, there are also negatives.
• There can be a premium on aggressiveness, which doesn’t serve well in the long run.
• Unlucky bounces can be frustrating.
• Short-term success can lead to widespread recognition without enough attention being paid to the likely durability and consistency of the record.
Overall, I think investing and sports are quite similar, and so are the decisions they call for.
Think about an American football game. The offense has the ball. They have four tries to make ten yards. If they don’t, the referee blows the whistle. The clock stops. Off the field goes the offense and on comes the defense, whose job it is to stop the other team from advancing the ball.
Is football a good metaphor for your view of investing? Well, I’ll tell you, it isn’t for mine. In investing there’s no one there to blow the whistle; you rarely know when to switch from offense to defense; and there aren’t any time-outs during which to do it.
No, I think investing is more like the “football” that’s played outside the United States—soccer. In soccer, the same eleven players are on the field for essentially the whole game. There isn’t an offensive squad and a defensive squad. The same people have to play both ways … have to be able to deal with all eventualities. Collectively, those eleven players must have the potential to score goals and stop the opposition from scoring more.
A soccer coach has to decide whether to field a team that emphasizes offense (in order to score a lot of goals and somehow hold the other team to fewer) or defense (hoping to shut out the other team and find the net once) or one that’s evenly balanced. Because coaches know they won’t have many opportunities to switch between offensive and defensive personnel during the game, they have to come up with a winning lineup and pretty much stick with it.
That’s my view of investing. Few people (if any) have the ability to switch tactics to match market conditions on a timely basis. So investors should commit to an approach—hopefully one that will serve them through a variety of scenarios. They can be aggressive, hoping they’ll make a lot on the winners and not give it back on the losers. They can emphasize defense, hoping to keep up in good times and excel by losing less than others in bad times. Or they can balance offense and defense, largely giving up on tactical timing but aiming to win through superior security selection in both up and down markets.
Oaktree’s preference for defense is clear. In good times, we feel it’s okay if we just keep up with the indices (and in the best of times we may even lag a bit). But even average investors make a lot of money in good times, and I doubt many managers get fired for being average in up markets.
SETH KLARMAN: Even if they did, Marks and his partners would certainly prefer to lose the handful of clients who held unrealistic expectations or who didn’t care for the Oaktree philosophy than to try to accommodate them. Ultimately, the Oaktree team manages a substantial amount of their own capital, and their approach has the same appeal to them that it should have to investors everywhere.
Oaktree portfolios are set up to outperform in bad times, and that’s when we think outperformance is essential. Clearly, if we can keep up in good times and outperform in bad times, we’ll have above-average results over full cycles with below-average volatility, and our clients will enjoy outperformance when others are suffering.
“WHAT’S YOUR GAME PLAN?” SEPTEMBER 5, 2003
What’s more important to you: scoring points or keeping your opponent from doing so? In investing, will you go for winners or try to avoid losers? (Or, perhaps more appropriately, how will you balance the two?) Great danger lies in acting without having considered these questions.
And, by the way, there’s no right choice between offense and defense. Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for.
What is offense in investing, and what is defense? Offense is easy to define. It’s the adoption of aggressive tactics and elevated risk in the pursuit of above-average gains. But what’s defense? Rather than doing the r
ight thing, the defensive investor’s main emphasis is on not doing the wrong thing.
Is there a difference between doing the right thing and avoiding doing the wrong thing? On the surface, they sound quite alike. But when you look deeper, there’s a big difference between the mind-set needed for one and the mind-set needed for the other, and a big difference in the tactics to which the two lead.
While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or nonaspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.
There are two principal elements in investment defense. The first is the exclusion of losers from portfolios. This is best accomplished by conducting extensive due diligence, applying high standards, demanding a low price and generous margin for error (see later in this chapter) and being less willing to bet on continued prosperity, rosy forecasts and developments that may be uncertain.
The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes. In addition to the ingredients described previously that help keep individual losing investments from the portfolio, this aspect of investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.
Concentration (the opposite of diversification) and leverage are two examples of offense. They’ll add to returns when they work but prove harmful when they don’t: again, the potential for higher highs and lower lows from aggressive tactics. Use enough of them, however, and they can jeopardize your investment survival if things go awry. Defense, on the other hand, can increase your likelihood of being able to get through the tough times and survive long enough to enjoy the eventual payoff from smart investments.
