by Howard Marks
One type of analytical error that I do want to spend some time on, however, is what I call “failure of imagination.” By that I mean either being unable to conceive of the full range of possible outcomes or not fully understanding the consequences of the more extreme occurrences.
CHRISTOPHER DAVIS: In other words, errors of quantification versus errors of judgment.
I go into this subject at greater length in the next section.
Many of the psychological or emotional sources of error were discussed in previous chapters: greed and fear; willingness to suspend disbelief and skepticism; ego and envy; the drive to pursue high returns through risk bearing; and the tendency to overrate one’s foreknowledge. These things contribute to booms and busts, in which most investors join together to do exactly the wrong thing.
Another important pitfall—largely psychological, but important enough to constitute its own category—is the failure to recognize market cycles and manias and move in the opposite direction. Extremes in cycles and trends don’t occur often, and thus they’re not a frequent source of error, but they give rise to the largest errors. The power of herd psychology to compel conformity and capitulation is nearly irresistible, making it essential that investors resist them. These, too, were discussed earlier.
“Failure of imagination”—the inability to understand in advance the full breadth of the range of outcomes—is particularly interesting, and it takes effect in many ways.
As I’ve said before, investing consists entirely of dealing with the future. In order to invest we must have a view of what the future will look like. In general, we have little choice but to assume it will look pretty much like the past. Thus, it’s relatively uncommon for anyone to say, “The average price/earnings ratio on U.S. stocks has been 15 over the last fifty years, and I predict that in the coming years it will be 10 (or 20).”
So most investors extrapolate the past into the future—and, in particular, the recent past. Why the recent past? First, many important financial phenomena follow long cycles, meaning those who experience an extreme event often retire or die off before the next recurrence. Second, as John Kenneth Galbraith said, the financial memory tends to be extremely short. And third, any chance of remembering tends to be erased by the promise of easy money that’s inevitably a part of the latest investment fad.
Most of the time the future is indeed like the past, so extrapolation doesn’t do any harm. But at the important turning points, when the future stops being like the past, extrapolation fails and large amounts of money are either lost or not made.
Thus, it’s important to return to Bruce Newberg’s pithy observation about the big difference between probability and outcome. Things that aren’t supposed to happen do happen. Short-run outcomes can diverge from the long-run probabilities, and occurrences can cluster. For example, double sixes should come up once in every 36 rolls of the dice. But they can come up five times in a row—and never again in the next 175 rolls—and in the long run have occurred as often as they’re supposed to.
Relying to excess on the fact that something “should happen” can kill you when it doesn’t. Even if you properly understand the underlying probability distribution, you can’t count on things happening as they’re supposed to. And the success of your investment actions shouldn’t be highly dependent on normal outcomes prevailing; instead, you must allow for outliers.
PAUL JOHNSON: The key to this wisdom is the phrase “you must allow for outliers.” Marks is unequivocal in his message.
Investors make investments only because they expect them to work out, and their analysis will center on the likely scenarios.
SETH KLARMAN: Similarly, the great majority of sell-side research focuses on a single, most likely scenario and ignores the range of possible outcomes.
But they mustn’t fixate on that which is supposed to happen to the exclusion of the other possibilities … and load up on risk and leverage to the point where negative outcomes will do them in. Most of the meltdowns in the recent credit crisis took place because something didn’t go as it was supposed to.
The financial crisis occurred largely because never-before-seen events collided with risky, levered structures that weren’t engineered to withstand them.
PAUL JOHNSON: A brilliantly simple explanation of the 2008 credit crisis, and beautifully said.
For example, mortgage derivatives had been designed and rated on the assumption that there couldn’t be a nationwide decline in home prices, since there never had been one (or at least not in the modern era of statistics). But then we had one of major proportions, and structures built on the assumption that it couldn’t happen were decimated.
As an aside, it’s worth noting that the assumption that something can’t happen has the potential to make it happen, since people who believe it can’t happen will engage in risky behavior and thus alter the environment. Twenty or more years ago, the term mortgage lending was associated inextricably with the word conservative. Home buyers put down 20 to 30 percent of the purchase price; mortgage payments were limited to 25 percent of monthly income by tradition; houses were appraised carefully; and borrowers’ income and financial position had to be documented. But when the appetite for mortgage-backed securities rose in the past decade—in part because mortgages had always performed so dependably and it was agreed there couldn’t be a nationwide surge in mortgage defaults—many of these traditional norms went out the window. The consequences shouldn’t have come as a surprise.
That brings me back to a dilemma we have to navigate. How much time and capital should an investor devote to protecting against the improbable disaster? We can insure against every extreme outcome; for example, against both deflation and hyperinflation. But doing so will be costly, and the cost will detract from investment returns when that protection turns out not to have been needed … and that’ll be most of the time. You could require your portfolio to do well in a rerun of 2008, but then you’d hold only Treasurys, cash and gold. Is that a viable strategy? Probably not. So the general rule is that it’s important to avoid pitfalls, but there must be a limit. And the limit is different for each investor.
There’s another important aspect of failure of imagination. Everyone knows assets have prospective returns and risks, and they’re possible to guess at. But few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third. Understanding and anticipating the power of correlation—and thus the limitations of diversification—is a principal aspect of risk control and portfolio management, but it’s very hard to accomplish. The failure to correctly anticipate co-movement within a portfolio is a critical source of investment error.
Investors often fail to appreciate the common threads that run through portfolios. Everyone knows that if one automaker’s stock falls, factors they have in common could make all auto stocks decline simultaneously. Fewer people understand the connections that could make all U.S. stocks fall, or all stocks in the developed world, or all stocks worldwide, or all stocks and bonds, etc.
So failure of imagination consists in the first instance of not anticipating the possible extremeness of future events, and in the second instance of failing to understand the knock-on consequences of extreme events.
CHRISTOPHER DAVIS: This is true.
In the recent credit crisis, some skeptics may have suspected that subprime mortgages would default in large numbers, but not necessarily that the ramifications would spread far beyond the mortgage market. Few people envisioned the mortgage collapse, but far fewer anticipated that as a result commercial paper and money market funds would be compromised; or that Lehman Brothers, Bear Stearns and Merrill Lynch would cease to exist as independent companies; or that General Motors and Chrysler would file for bankruptcy and require bailouts.
In many ways, psychological forces are some of the most interesting sources of investment error. They can greatly influence security prices. When they cause some inv
estors to take an extreme view that isn’t balanced out by others, these forces can make prices go way too high or way too low. This is the origin of bubbles and crashes.
How are investors harmed by these forces?
• By succumbing to them
• By participating unknowingly in markets that have been distorted by others’ succumbing
• By failing to take advantage when those distortions are present
Are these all the same thing? I don’t think so. Let’s dissect these three mistakes in the context of one of the most insidious psychological forces: greed.
When greed goes to excess, security prices tend to be too high. That makes prospective return low and risk high. The assets in question represent mistakes waiting to produce loss … or to be taken advantage of.
The first of the three errors just listed—succumbing to negative influences—means joining in the greed and buying. If the desire to make money causes you to buy even though price is too high, in the hope that the asset will continue appreciating or the tactic will keep working, you’re setting yourself up for disappointment. If you buy when price exceeds intrinsic value, you’ll have to be extremely lucky—the asset will have to go from overvalued to even more overvalued—in order to experience gain rather than loss. Certainly the elevated price renders the latter more likely than the former.
The second of the errors is something we might call the error of not noticing. You may not be motivated by greed; for example, your 401(k) plan may invest in the stock market steadily and passively through an index fund. Nevertheless, participating, even unknowingly, in a market that has become elevated because of undisciplined buying by others has serious implications for you.
Each negative influence, and each kind of “wrong” market, presents ways to benefit instead of err. Thus, the third form of error doesn’t consist of doing the wrong thing, but rather of failing to do the right thing. Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them. Most investors would hope to not buy, or perhaps even to sell, when greed has driven a stock’s price too high. But superior investors might sell it short in order to profit when the price falls. Committing the third form of error—e.g., failing to short an overvalued stock—is a different kind of mistake, an error of omission, but probably one most investors would be willing to live with.
As I mentioned before, among the pitfalls attributable to psychology is investors’ occasional willingness to accept the novel rationales that underlie bubbles and crashes, usually out of a belief that “it’s different this time.” In bullish markets, inadequate skepticism makes this a frequent occurrence, as investors accept that
• some new development will change the world,
• patterns that have been the rule in the past (like the ups and downs of the business cycle) will no longer occur,
• the rules have been changed (such as the standards that determine whether companies are creditworthy and their debt worth holding), or
• traditional valuation norms are no longer relevant (including price/earnings ratios for stocks, yield spreads for bonds or capitalization rates for real estate).
Because of the way the pendulum swings (see chapter 9), these errors often occur simultaneously, when investors become too believing and default on the requirement to be skeptical.
There’s always a rational—perhaps even a sophisticated—explanation of why some eighth wonder of the world will work in the investor’s favor. However, the explainer usually forgets to mention that (a) the new phenomenon would represent a departure from history, (b) it requires things to go right, (c) many other things could happen instead and (d) many of those might be disastrous.
The essential first step in avoiding pitfalls consists of being on the lookout for them. 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. But learning about pitfalls through painful experience is of only limited help. The key is to try to anticipate them. To illustrate, I turn to the recent credit crisis.
The markets are a classroom where lessons are taught every day. The keys to investment success lie in observing and learning. In December 2007, with the subprime problem well under way and its potential for contagion to other markets in the process of becoming clear, I set out to enumerate the lessons that I thought should be learned from it. By the time I completed that task, I realized that these weren’t just the lessons of the latest crisis, but key lessons for all time. While I’ve touched on many of these elsewhere, you may benefit from seeing them all together in one place.
PAUL JOHNSON: The lessons to be learned from the 2008 crisis, listed below, are well articulated and brilliantly insightful. Not much more needs to be said on the forces that devastated so many investment portfolios and financial services companies.
What We Learn from a Crisis—or Ought To
• Too much capital availability makes money flow to the wrong places. When capital is scarce and in demand, investors are faced with allocation choices regarding the best use for their capital, and they get to make their decisions with patience and discipline. But when there’s too much capital chasing too few ideas, investments will be made that do not deserve to be made.
• When capital goes where it shouldn’t, bad things happen. In times of capital market stringency, deserving borrowers are turned away. But when money’s everywhere, unqualified borrowers are offered money on a silver platter. The inevitable results include delinquencies, bankruptcies and losses.
• When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error. When people want to buy something, their competition takes the form of an auction in which they bid higher and higher. When you think about it, bidding more for something is the same as saying you’ll take less for your money. Thus, the bids for investments can be viewed as a statement of how little return investors demand and how much risk they’re willing to accept.
CHRISTOPHER DAVIS: This is one of the reasons that we always think in terms of earnings yield (which is just the inverse of the P/E) rather than in P/Es; doing so allows for easy comparison to fixed-income alternatives.
• Widespread disregard for risk creates great risk. “Nothing can go wrong.” “No price is too high.” “Someone will always pay me more for it.” “If I don’t move quickly, someone else will buy it.” Statements like these indicate that risk is being given short shrift. This cycle’s version saw people think that because they were buying better companies or financing with more borrower-friendly debt, buyout transactions could support larger and larger amounts of leverage. This caused them to ignore the risk of untoward developments and the danger inherent in highly leveraged capital structures.
• Inadequate due diligence leads to investment losses. The best defense against loss is thorough, insightful analysis and insistence on what Warren Buffett calls “margin for error.” But in hot markets, people worry about missing out, not about losing money, and time-consuming, skeptical analysis becomes the province of old fogeys.
• In heady times, capital is devoted to innovative investments, many of which fail the test of time. Bullish investors focus on what might work, not what might go wrong. Eagerness takes over from prudence, causing people to accept new investment products they don’t understand. Later, they wonder what they could have been thinking.
• Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. It’s easier to assess the return and risk of an investment than to understand how it will move relative to others. Correlation is often underestimated, especially because of the degree to which it increases in crisis. A portfolio may
appear to be diversified as to asset class, industry and geography, but in tough times, nonfundamental factors such as margin calls, frozen markets and a general rise in risk aversion can become dominant, affecting everything similarly.
• Psychological and technical factors can swamp fundamentals. In the long run, value creation and destruction are driven by fundamentals such as economic trends, companies’ earnings, demand for products and the skillfulness of managements. But in the short run, markets are highly responsive to investor psychology and the technical factors that influence the supply and demand for assets. In fact, I think confidence matters more than anything else in the short run. Anything can happen in this regard, with results that are both unpredictable and irrational.
JOEL GREENBLATT: The market eventually gets it right. In the short term, psychology and technical factors can make the wait for the long term exceptionally painful, but often this is the source of great opportunity.
• Markets change, invalidating models. Accounts of the difficulties of “quant” funds center on the failure of computer models and their underlying assumptions. The computers that run portfolios attempt primarily to profit from patterns that held true in past markets. They can’t predict changes in those patterns; they can’t anticipate aberrant periods; and thus they generally overestimate the reliability of past norms.
CHRISTOPHER DAVIS: Or as Buffett has said, “Beware of geeks with models.”
• Leverage magnifies outcomes but doesn’t add value. It can make great sense to use leverage to increase your investment in assets at bargain prices offering high promised returns or generous risk premiums. But it can be dangerous to use leverage to buy more of assets that offer low returns or narrow risk spreads—in other words, assets that are fully priced or overpriced. It makes little sense to use leverage to try to turn inadequate returns into adequate returns.
