Earlier this summer, Howard Marks did an episode of the Masters in Business podcast. Several topics were covered from risk control, market cycles, predicting the future, and understanding the past.
There was some mild interest in my notes on a previous presentation Marks gave on his investment philosophy. So I went back and organized my notes from this interview as well.
For Marks, the most important job is risk control. In his case, risk is permanent loss or avoiding big blowups. So what should you do about the improbable disaster? You can’t prepare for every outcome. Sometimes it’s a risk you can live with, sometimes you have to avoid it.
The key question to ask before buying or selling anything is “Should your portfolio be aggressive or defensive?” If you don’t ask this question, you’ll eventually fail. If you do ask it, you’ll most likely succeed. Of course, you only have two options when assets are on the high side of fair (or expensive) – 1) go defensive but risk missing out, or 2) put money to work but carefully.
A big part of risk control is understanding valuation and getting in at a low price. You can’t buy anything for less, with a margin of safety, until you truly understand what things are worth.
Another aspect of risk control is a cash allocation. Cash is king when opportunities come along, especially when few opportunities exist at present.
The one thing Marks wished you knew when he started was situational awareness and knowing when to be a contrarian and when to step aside.
Predicting The Future
Nobody can predict the future. Yet, nobody wants to hear “I don’t know” from their financial expert. Most people would rather hear a prediction, some guess about the future, however wrong, than hear the truth.
The future does not exist. It is only a range of possibilities. We have to understand that most outcomes will be determined by luck.
The world, economies, and markets run according to randomness. If A happens, it doesn’t mean B must then happen. The world is not a math formula. C, D, or E are also possibilities. The world is uncertain and always changing.
We can make excellent investment decisions on the basis of present observations with no need to make guesses about the future.
We never know where we’re going, but we sure as hell should know where we are.
You can only cope with the world if you think probabilistically. You can’t predict, you can prepare. Part of that preparation involves understanding where we are at present. Where are we in the current market cycle? Where does investor sentiment stand?
Marks believes that one of the best ways to manage risk is by understanding market cycles.
Rule #1 – most things prove to be cyclical. Rule #2 – some of the greatest opportunities from gain and loss comes when other people forget rule #1.
The three stages of a bull market: 1) only a few people believe things could ever get better, 2) most people understand improvement is taking place, 3) everyone believes it will get better forever.
The point is you should know which stage you’re in and you should act accordingly.
He broke down the variables driving the market into three areas – direction of the economy, investor psychology, and market valuation. All three influence asset prices.
Herd behavior moves in cycles – fear to prudence to greed and back. Understanding the mindset of the herd helps you manage risk.
You have to understand your psyche and the psyche of those around you.
You should know what other people are thinking via the information available online. Watch out for serial bad behavior from the herd – cycles of fear and greed. Be cautious when the herd is aggressive. Be aggressive when the herd is overly cautious.
“When things go well, standards decline, they require less creditworthiness, they do more deals, they take more risk, because what the hell, they figure the more risk you take, the more money you make.” – Another cycle that never ends well!
Japanese philosophy taught him “the turning of the wheel of the law” meaning “change and impermanence are forever.”
People should read broadly. You have to see the whole world to understand what’s going on, including different disciplines, like how people thought over the years, to see the cycles. Reading makes you think bigger.
His favorite quote from Galbraith:
Anybody who remembers the old bad events and cautions against the recurrence is dismissed as past their prime. – Galbraith
The quote is a reminder that history is relevant but regularly pushed aside and ignored. It describes the shortcomings of the markets perfectly.
That dismissal of the past has regular helpers like a get rich quick idea that only works if you forget (or never knew) that it didn’t work in the past.
On Having an Investment Philosophy
Investors need a creed. You have to have something to stand by – a philosophy, a process, a system. The great investors have a simple philosophy they always stand by.
On Short-Term Thinking
Tech makes the short term (and the long term) even shorter. The thought process around time is shrinking. Shortsightedness is the single worst development in history.
On the Not As Bad As Mentality Toward Yield
Do you really want to buy something for your investment portfolio because it’s not as bad as something else? No!
When not as bad as morphs into always better than, watch out.
- “The real way to build wealth in the long run, is to find a limited number of things with a lot of potential, and not too much risk, and stay with them for the long term.”
- “The real success in investing goes to people who achieve a superior understanding of things that are going on, why they are going on, and what they mean.”
- “If you think the same as everybody else, you’ll behave the same. And if you behave the same as everybody else, you can’t expect to outperform.”
- “In a world where nobody has any money, there’s a great premium on cash.” – regarding the financial crisis.
- “It takes a lot longer for things to happen than you think it could, but then they happen much faster than you think they will.”
- “The crowd finds it easier to buy things that have been rising for a while. And very hard to buy things that have fallen.”
- “The secret to solving all problems starts with awareness of that problem.” – regarding avoiding the winner’s curse.
- A Short History of Financial Euphoria
- Fooled by Randomness
- Against the Gods
- Poor Charlie’s Almanac
- The Warren Buffett Way
- The Most Important Thing