The Most Important Thing

Published in 2020, these notes discuss Howard Marks's investment framework from that period.

The Most Important Thing by Howard Marks offers you “uncommon sense for the thoughtful investor”. The book hopes to install an investment philosophy in you that will help you do well with your money.

I’ve started this book quite some years ago (say 2014) and am now re-reading it and making my notes here.

This book review is also part of my Financial Independence project/essay.

Introduction

“Successful investing requires thoughtful attention to many separate aspects, all at the same time.” Essentially the introduction says to get information from a wide variety of sources. The notes also say that hard times can teach you a lot. Take action on what you’ve learned.

The Most Important Thing Is … (chapter)

1. Second Level Thinking

No rule always works. Think one step beyond the obvious. If the stock is high, is it too high or maybe even still undervalued?

2. Understanding Market Efficiency (and Its Limitations)

The market reflects the consensus view/price. So only with an unconventional perspective, can you make (more) money. You are betting on inefficiencies in the market. The inefficiencies may only be there for a certain time.

3. Value

Investment strategies can be based on fundamentals or price behaviour. I think the second approach sucks because of the Random Walk: historic prices do not predict future prices. Fundamental investing can be divided into:

• Value investing (intrinsic value)
  • Current value is higher than the price
• Growth investing (find companies that will grow fast in the future)
  • Company will outgrow current (correct) price

Growth investing is more difficult (more uncertainty).

4. The Relationship Between Price and Value

“If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value” Psychology and technical factors can still move the price. I noted groupthink and bias as psychological influences (including an earlier example involving Alphabet), and forced selling during a crisis as a technical one.

“People should like something less when its price rises, but in investing they often like it more” The routes to investment profits are:

• Benefiting from a rise in the asset’s intrinsic value
• Applying leverage (borrowing money, thus making/losing more)
• Selling for more than your asset’s worth
• Buying something for less than its value

5. Understanding Risk

Risk-adjusted return looks at the return you’ve made, in light of the risk (uncertainty, wider range of outcomes) that you took. The possibility of permanent loss is the worst risk. “There’s a big difference between probability and outcome. Probable things fail to happen – and improbable things happen – all the time” Think of the Black Swan concept by Nassim Taleb (fat tail risks). So protect yourself in case very bad things happen. We don’t fully ‘grog’ risk if we look back at the past (one outcome) as we try to predict the future (many outcomes possible). We underestimate the biggest risk (e.g. global pandemic – written 24 March 2020). Risk lumps together (sometimes many bad things happen at the same time for no reason).

6. Recognizing Risk

Risk increases during upswings, and materializes during recessions. “Risk tolerance is antithetical to successful investing” If stocks are high, people believe the risk is gone (not true). Investment risk is exactly there where it isn’t predicted/expected.

7. Controlling Risk

Risk is not visible, only losses (when risk and negative events collide). So if there are no losses, that doesn’t mean there wasn’t risk. Good portfolios have either lower risk or higher returns than average. Prepare for one-in-a-generation events (as you can’t prepare for everything). Professional investors are not in the market to make 4% (but more like 8%), so living without risk is not possible.

8. Being Attentive to Cycles

There are always cycles (ups and downs). Remember this rule and profit when others forget it. “The worst loans are made at the best of times” (because no one thinks there is risk – cycle turns around and ouch). Just when people predict the market can never fall again, it probably will.

9. Awareness of the Pendulum

The markets (and actors on the market) move like a pendulum, almost never being in the middle. For example, between euphoria and depression, between overpriced and underpriced. The pendulum regarding risk attitudes is the most important one. The extreme attitude at one side of the pendulum will reverse.

10. Combating Negative Influences

Human nature (psychology) often leads to making the wrong decisions. Greed and optimism, or conversely fear, are examples. Another example is to conform to the view of the herd, rather than resist. So stick to intrinsic value (of a company). Act out your plan (not based on your spur-of-the-moment feelings). If things look ‘too good to be true’, they are. Be willing to look wrong when the market is misvalued. Find a support group / like-minded people.

11. Contrarianism

“As the pendulum swings or the market goes through its cycles, the key to ultimate success lies in doing the opposite” When the market is at an extreme (up or down), it reflects an inflection point (so be a contrarian). “buy when they hate ’em, and sell when they love ’em” It won’t be easy, you still need to have the ability to know when prices have diverged from their intrinsic value. Most of the time this won’t apply. And timing is everything, overprices doesn’t equal going down now. So only do something contrarian, when you know the crowd is wrong.

12. Finding Bargains

1. buy best investments
2. make room for them by selling lesser ones
3. stay clear of the worst

Finding bargains requires rigour and discipline. I noted undervalued bonds as one example: other investors may irrationally regard an asset as unattractive even when its underlying situation is better than its reputation.

13. Patient Opportunism

Wait for investments to come to you, don’t go searching for them (by changing your criteria). Don’t ‘reach for returns’, to try and get a return when the market is not offering it (at your risk level). Buy when others are forced to sell (in a crisis, they sell because they need to, not because the asset is bad).

14. Knowing What You Don’t Know

You cannot see the whole picture. You may be able to say something with confidence when you focus closely enough, such as where you think the market stands in a cycle or pendulum. I think forecasts suck: they often extrapolate the past and offer little value. Overestimating what you know is, in these notes, the greatest vice.

15. Having a Sense for When We Stand

You can’t know when the market turns, but you can know/estimate where on a cycle you are. Understand the present. What can you infer from that?

16. Appreciating the Role of Luck

An improbable bet can pay off without proving that the investor is skilled. Only over the long term, I thought, can you see who is really skilled; my notes link this to alternative histories and the outcomes that might have occurred. Surviving a downturn matters more to me than winning in the short term while taking risks that could lead to a later loss.

17. Investing Defensively

Avoiding losses matters more than picking winners. A margin of safety leaves room for error: if things go wrong, can you survive? Buying at a sufficiently low price can provide that margin.

18. Avoiding Pitfalls

“An investor needs do very few things right as long as he avoids big mistakes – Warren Buffet” Sources of error are analytical or psychological/emotional. In the former, there is the ‘failure of imagination’, not being able to conceive of all possible scenarios.

Investors can have short, optimistic memories and fail to imagine a crisis arising when improbable events meet existing risks. It also matters whether assets in a portfolio are correlated, since several can rise or fall together.

The latter concerns many things already discussed (greed, mania). Some tips on avoiding pitfalls:

• take note of carefree, incautious behaviour of others
• prepare psychologically for a downturn
• sell risky assets
• reduce leverage
• raise cash (personal note: to buy when market is low again)
• tilt portfolio towards increased defensiveness

19. Adding Value

My notes describe beta as relative skill in relation to the market, alpha as personal investment skill unrelated to market movement, and y as portfolio performance in the expression y = a + βx. I would consider both measures alongside an investor’s aggressive or defensive risk profile. Oaktree, the firm Marks co-chairs, aims for roughly average results in good years and relatively smaller losses in bad years.

20. Putting It All Together

The final chapter draws the earlier lessons together: add value by performing reliably and with skill.