The “Illuminated” edition of The Most Important Thing by Howard Marks is filled with great commentary from other investors throughout the book.
Except, when you read it for the first time it can be a bit disruptive. It’s as if a random person is constantly adding their two cents while you’re in the middle of a conversation with the author.
Where the comments really become useful is when you go through the book a second time. Having the likes of Joel Greenblatt, Seth Klarman and others offer insights helps to tie things together.
And even Marks adds comments on his writing. Though, he tags his comments with themes.
The most important of those themes he labels “the riskiest things.” The not so obvious way to sum it up is the riskiest things turn out to be things that seem the least risky.
That runs counter to how most people think. But after the fact, as risk is realized, it’s more obvious. Excessively high prices happen not because investors weigh risk but because they excessively discount risk.
The reality of risk is much less simple and straightforward than the perception. People vastly overestimate their ability to recognize risk and underestimate what it takes to avoid it; thus, they accept risk unknowingly and in so doing contribute to its creation. That’s why it’s essential to apply uncommon, second-level thinking to the subject.
Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as their psychology strengthens and they become bolder and less worried, investors cease to demand adequate risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.
Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the “perversity of risk.”
It’s why rules of thumb aren’t written stone. It’s because markets adapt that rules of thumb work often but not always.
When investors feel risk is high, their actions serve to reduce risk. But when investors believe risk is low, they create dangerous conditions. The market is dynamic rather than static, and it behaves in ways that are counterintuitive.
This is why great companies can be bad investments, terrible companies can be good investments, “safe” bonds can be risky, and junk bonds can be safe.
It’s all due to the connection between price and value.
Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship — and the outlook for it — lies largely in insight into other investors’ minds. Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.
The discipline that is most important is not accounting or economics, but psychology. The key is who likes the investment now and who doesn’t. Future price changes will be determined by whether it comes to be liked by more people or fewer people in the future.
Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge.
The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.
Joel Greenblatt left a comment to this quote, weighing in on what’s more important: understanding analysis or psychology:
Once again, as Buffett would say, the best investment class would teach how to estimate value and then how to think about market prices. Merely understanding that prices can deviate wildly from value over the short run is key. Understanding psychology so that you can take advantage of these deviations when they appear is the hard part.
The point is that expert analysis is useless if you get caught up in the popularity contest too. The most important thing is controlling your behavior.