by Howard Marks
The relationship between price and value is influenced by psychology and technicals, forces that can dominate fundamentals in the short run. Extreme swings in price due to those two factors provide opportunities for big profits or big mistakes. To have it be the former rather than the latter, you must stick with the concept of value and cope with psychology and technicals.
Economies and markets cycle up and down. Whichever direction they’re going at the moment, most people come to believe that they’ll go that way forever. This thinking is a source of great danger since it poisons the markets, sends valuations to extremes, and ignites bubbles and panics that most investors find hard to resist.
Likewise, the psychology of the investing herd moves in a regular, pendulum-like pattern—from optimism to pessimism; from credulousness to skepticism; from fear of missing opportunity to fear of losing money; and thus from eagerness to buy to urgency to sell. The swing of the pendulum causes the herd to buy at high prices and sell at low prices. Thus, being part of the herd is a formula for disaster, whereas contrarianism at the extremes will help to avert losses and lead eventually to success.
In particular, risk aversion—an appropriate amount of which is the essential ingredient in a rational market—is sometimes in short supply and sometimes excessive. The fluctuation of investor psychology in this regard plays a very important part in the creation of market bubbles and crashes.
The power of psychological influences must never be underestimated. Greed, fear, suspension of disbelief, conformism, envy, ego and capitulation are all part of human nature, and their ability to compel action is profound, especially when they’re at extremes and shared by the herd. They’ll influence others, and the thoughtful investor will feel them as well. None of us should expect to be immune and insulated from them. Although we will feel them, we must not succumb; rather, we must recognize them for what they are and stand against them. Reason must overcome emotion.
Most trends—both bullish and bearish—eventually become overdone, profiting those who recognize them early but penalizing the last to join. That’s the reasoning behind my number one investment adage: “What the wise man does in the beginning, the fool does in the end.” The ability to resist excesses is rare, but it’s an important attribute of the most successful investors.
It’s impossible to know when an overheated market will turn down, or when a downturn will cease and appreciation will take its place. But while we never know where we’re going, we ought to know where we are. We can infer where markets stand in their cycle from the behavior of those around us. When other investors are unworried, we should be cautious; when investors are panicked, we should turn aggressive.
Not even contrarianism, however, will produce profits all the time. The great opportunities to buy and sell are associated with valuation extremes, and by definition they don’t occur every day. We’re bound to also buy and sell at less compelling points in the cycle, since few of us can be content to act only once every few years. We must recognize when the odds are less in our favor and tread more carefully.
Buying based on strong value, low price relative to value, and depressed general psychology is likely to provide the best results. Even then, however, things can go against us for a long time before turning as we think they should. Underpriced is far from synonymous with going up soon. Thus the importance of my second key adage: “Being too far ahead of your time is indistinguishable from being wrong.” It can require patience and fortitude to hold positions long enough to be proved right.
In addition to being able to quantify value and pursue it when it’s priced right, successful investors must have a sound approach to the subject of risk. They have to go well beyond the academics’ singular definition of risk as volatility and understand that the risk that matters most is the risk of permanent loss. They have to reject increased risk bearing as a surefire formula for investment success and know that riskier investments entail a wider range of possible outcomes and a higher probability of loss. They have to have a sense for the loss potential that’s present in each investment and be willing to bear it only when the reward is more than adequate.
Most investors are simplistic, preoccupied with the chance for return. Some gain further insight and learn that it’s as important to understand risk as it is return. But it’s the rare investor who achieves the sophistication required to appreciate correlation, a key element in controlling the riskiness of an overall portfolio. Because of differences in correlation, individual investments of the same absolute riskiness can be combined in different ways to form portfolios with widely varying total risk levels. Most investors think diversification consists of holding many different things; few understand that diversification is effective only if portfolio holdings can be counted on to respond differently to a given development in the environment.
While aggressive investing can produce exciting results when it goes right—especially in good times—it’s unlikely to generate gains as reliably as defensive investing. Thus, a low incidence and severity of loss is part of most outstanding investment records. Oaktree’s motto, “If we avoid the losers, the winners will take care of themselves,” has served well over the years. A diversified portfolio of investments, each of which is unlikely to produce significant loss, is a good start toward investment success.
Risk control lies at the core of defensive investing. Rather than just trying to do the right thing, the defensive investor places a heavy emphasis on not doing the wrong thing. Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in good times, investors must decide what balance to strike between the two. The defensive investor chooses to emphasize the former.
Margin for error is a critical element in defensive investing. Whereas most investments will be successful if the future unfolds as hoped, it takes margin for error to render outcomes tolerable when the future doesn’t oblige. An investor can obtain margin for error by insisting on tangible, lasting value in the here and now; buying only when price is well below value; eschewing leverage; and diversifying. Emphasizing these elements can limit your gains in good times, but it will also maximize your chances of coming through intact when things don’t go well. My third favorite adage is “Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average.” Margin for error gives you staying power and gets you through the low spots.
Risk control and margin for error should be present in your portfolio at all times. But you must remember that they’re “hidden assets.” Most years in the markets are good years, but it’s only in the bad years—when the tide goes out—that the value of defense becomes evident. Thus, in the good years, defensive investors have to be content with the knowledge that their gains, although perhaps less than maximal, were achieved with risk protection in place … even though it turned out not to be needed.
One of the essential requirements for investment success—and thus part of most great investors’ psychological equipment—is the realization that we don’t know what lies ahead in terms of the macro future. Few people if any know more than the consensus about what’s going to happen to the economy, interest rates and market aggregates. Thus, the investor’s time is better spent trying to gain a knowledge advantage regarding “the knowable”: industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don’t.
Many more investors assume they have knowledge of the future direction of economies and markets—and act that way—than actually do. They take aggressive actions predicated on knowing what’s coming, and that rarely produces the desired results. Investing on the basis of strongly held but incorrect forecasts is a source of significant potential loss.
Many investors—amateurs and professionals alike—assume the world runs on orderly processes that can be mastered and predicted. They ignore the randomness of things and the probability distribution that underlies future developments. Thus, they
opt to base their actions on the one scenario they predict will unfold. This works sometimes—winning kudos for the investor—but not consistently enough to produce long-term success. In both economic forecasting and investment management, it’s worth noting that there’s usually someone who gets it exactly right … but it’s rarely the same person twice. The most successful investors get things “about right” most of the time, and that’s much better than the rest.
An important part of getting it right consists of avoiding the pitfalls that are frequently presented by economic fluctuations, companies’ travails, the markets’ manic swings, and other investors’ gullibility. There’s no surefire way to accomplish this, but awareness of these potential dangers certainly represents the best starting point for an effort to avoid being victimized by them.
Another essential element is having reasonable expectations. Investors often get into trouble by acting on promises of returns that are unreasonably high or dependable, and by overlooking the fact that, usually, every increase in return pursued is accompanied by an increase in risk borne. The key is to think long and hard about propositions that may be too good to be true.
Neither defensive investors who limit their losses in a decline nor aggressive investors with substantial gains in a rising market have proved they possess skill. For us to conclude that investors truly add value, we have to see how they perform in environments to which their style isn’t particularly well suited. Can the aggressive investor keep from giving back gains when the market turns down? Will the defensive investor participate substantially when the market rises? This kind of asymmetry is the expression of real skill. Does an investor have more winners than losers? Are the gains on the winners bigger than the losses on the losers? Are the good years more beneficial than the bad years are painful? And are the long-term results better than the investor’s style alone would suggest? These things are the mark of the superior investor. Without them, returns may be the result of little more than market movement and beta.
Only investors with unusual insight can regularly divine the probability distribution that governs future events and sense when the potential returns compensate for the risks that lurk in the distribution’s negative left-hand tail.
HOWARD MARKS: Understanding uncertainty: The sentence above does a good job of describing what it takes to deal with uncertainty: a feeling for the things that can happen, the relative likelihood of each, and whether an asset’s price (and thus the potential for gains from that price) provides adequate potential reward for bearing the uncertainty that is present.
This simple description of the requirements for successful investing—based on understanding the range of possible gains and the risk of untoward developments—captures the elements that should receive your attention. I commend the task to you. It’ll take you on a challenging, exciting and thought-provoking journey.
JOEL GREENBLATT: A good understanding of value and how to think about price movements is the key to successful investing. While there are many smart people who can master the estimation of value (especially if they are disciplined enough to stay within what Buffett calls their “circle of competence”), most investors fall short in the area of contextualizing market and individual security price movements. This is where the lessons from Marks’s book are so essential. So please feel free to read this chapter (and the entire book!) again and again—a true investment classic.
About the Contributors
CHRISTOPHER C. DAVIS has more than twenty years of experience in investment management and securities research. He is a portfolio manager of the Davis Large Cap Value portfolios and a member of the research team of other portfolios. Davis joined the firm in 1989. He received his M.A. from the University of St. Andrews in Scotland.
JOEL GREENBLATT is a managing partner of Gotham Capital, a hedge fund that he founded in 1985. He has been a professor since 1996 on the adjunct faculty of Columbia Business School, where he teaches value and special-situation investing. Greenblatt is the former chairman of the board of Alliant Techsystems, a NYSE-listed aerospace and defense company. He is the author of three books: The Big Secret for the Small Investor (Crown Business, 2011), The Little Book That Beats the Market (John Wiley & Sons, 2005) and You Can Be a Stock Market Genius (Simon & Schuster, 1997). Greenblatt holds a B.S. and an M.B.A from the Wharton School.
BRUCE C. GREENWALD holds the Robert Heilbrunn Professorship of Finance and Asset Management at Columbia Business School and is the academic director of the Heilbrunn Center for Graham and Dodd Investing. Since 2007 Greenwald has also served as director of research for First Eagle Funds, a division of Arnhold and S. Bleichroeder Advisers, L.L.C. Greenwald is the author of several books, including Competition Demystified: A Radically Simplified Approach to Business Strategy (with Judd Kahn, Putnam Penguin, 2005), and Value Investing: From Graham to Buffett and Beyond (with Judd Kahn et al, Wiley, 2001). Greenwald has received a B.S. and a Ph.D. from the Massachusetts Institute of Technology, and an M.P.A. and M.S. from Princeton University.
PAUL JOHNSON founded Nicusa Capital, a fundamentally driven value-oriented long–short hedge fund, in January 2003, and has more than twenty-five years of experience as an investment professional. As an adjunct professor of finance at the Graduate School of Business, Columbia University, Johnson has taught twenty courses since 1992 on securities analysis and value investing to more than six hundred students. He has an M.B.A. in finance from the Executive Program at the Wharton School of the University of Pennsylvania, and a B.A. in economics from the University of California, Berkeley.
SETH A. KLARMAN is the president of The Baupost Group, L.L.C., which currently manages approximately $23 billion on behalf of individual and institutional clients. He has been with the company since its inception in 1982. Author of Margin of Safety (Harper-Collins, 1991), a book that outlines his value investment philosophy, Klarman was chosen as lead editor for Security Analysis, Sixth Edition (McGraw-Hill, 2008) and has been featured in a variety of investment industry publications. He is a 1982 graduate of Harvard Business School, where he was a Baker Scholar, and received his B.A. in economics from Cornell University in 1979.
