Howard Marks is a philosopher of risk management. His quarterly memos are a crash course on the subject.
Marks got his start as an equity analyst at Citicorp in the late 1960s. It was the peak of the Nifty-Fifty. They were considered one-decision stocks. The companies were so great that you could buy them at any price. Citicorp and many investors took it to heart and the Nifty-Fifty stocks traded upwards of 80x earnings.
Over the next five years, Marks watched the Nifty-Fifty’s stock prices fall 70% or more in price. It provided the perfect lesson that even the best companies can be risky at too high a price.
His attention switched to junk bonds as Micheal Milken drove the junk bond craze in the 1980s. It was here that Marks applied Ben Graham’s “negative art” running a portfolio of high-yield bonds.
Unlike stocks, bonds typically have limited upside, so not losing is of the utmost importance. Because if you buy a basket of bonds that all yield 6%, the best you can earn is 6% per year from now to maturity. The risk is that a company behind a bond stops paying, the bond falls in price, and your returns fall short of 6%. So the goal of bond investing is to filter out the bonds that won’t pay. Loss avoidance is the priority.
Loss avoidance was equally important when Marks started one of the first distressed debt funds for TCW in 1988. Distressed debt offered a potential upside, unlike his previous bond fund. Seven years later he, with several colleagues, founded Oaktree Capital and infused risk management into its philosophy.
Oaktree’s motto is, “If we avoid the losers, the winners take care of themselves.” That’s a mindset; it’s not a roadmap.
That mindset is a reminder for everyone that surviving what the market dishes out is the most important thing…at least one of several important things.
In 2011, Marks published his first book, The Most Important Thing (notes), on what is most important to investing success. He followed that up with Mastering the Market Cycle (notes) in 2018.
In other words, investors can learn a lot from Howard Marks.
On Risk Management
Whenever we consider an investment, we think just as much or more about what can go wrong as about what can go right, and we put the avoidance of losses on a high pedestal. That’s not the only thing we consider, but we put it first.
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One of my favorite adages is this one: Never forget the six-foot-tall man who drowned crossing the river that was five feet deep on average. The important thing to remember about investing is that it is not sufficient to set up a portfolio that will survive on average. The key is to survive at the low ends.
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When you want to understand the perversity of risk, it’s important to recognize that the riskiness of investing comes only partly from the things you invest in. A lot of the risk comes from the behavior of the participants. Almost any asset can be risky or safe, depending on how other investors treat it.
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As an investor, you have to deal with two risks: The risk of losing money, and the risk of missing out on opportunities. It’s the job of a good investor to balance the two… It’s precisely when people can’t see what it is that could make things turn down that risk is the highest. It could be an economic slowdown, rising interest rates, the effect of central bank tightening, or geopolitical events. Or it could be “something else.” It’s always the things we don’t know about that really bite us in the end.
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Most of the outstanding investors that I have known over the years belong to the “I don’t know” school with regard to the macro environment. They may know companies and securities better than anybody else in the world, but with regard to the macro they assume that they don’t know what the future holds. So they hedge against uncertainty. They diversify. They avoid or limit leverage, and they emphasize the avoidance of losses rather than – or I would say as least as important as – the acquisition of gains.
On Investing Mistakes
As wrong as it is to sell appreciated assets solely to harvest gains, it’s even worse to sell things just because they’re down. While the old saw says we should “buy low, sell high”, clearly many people become more motivated to sell assets the more they decline. They worry about letting losses compound, but selling things just because they’re down is a mistake that can provide great opportunities to other investors. Further, investors often engage in selling because they believe a decline is imminent and they have the ability to avoid it. However, there are very few people who possess the skill needed to profit from market timing.
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If you do a little trading all the time it is going to be a disaster. I always wondered what would happen if we set up a trading room so that it only accepted orders on Thursdays. And in between, all people could do is think. Maybe you would do better… I believe denying clients the ability to be hyper-traders is doing them a favor. Most people are not adept enough to take advantage of short-term mis-valuations, and I put myself in that category.
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One of the biggest mistakes you can make is to think that overpriced and going down tomorrow are synonymous. Markets that are overpriced often keep going. And you know, well, Keynes said it best of anybody. He said markets could remain irrational longer than you can remain solvent… As long as you realize that nothing is sure to happen in this business, every irrationality can be exceeded, that means that you should try to bullet proof your affairs so that it may be likely to happen, but you want to be able to last long enough so that you’re around when it happens.
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People always say they’ll stay in the market, thinking it has further to go, but if it starts to turn down they will get out. Maybe that’s what people are thinking in today’s stock market: “It will continue to go up, but I will get out in time.” People overestimate their ability to get out in time. Who will be there to buy when everyone wants to sell? That’s wishful thinking.
On Short-Term Luck
It’s important to recognize what I call the twin impostors. They are short-term gain or outperformance, and short-term underperformance. Both are impostors, because neither one says anything about real investment skill. Investing performance is what happens when events collide with an existing portfolio. Maybe a portfolio has been assembled very wisely, very prudently, and with a lot of analytical talent, and the events that occur just were unforeseeable. That doesn’t mean the performance that results tells you anything about the wisdom of the portfolio or the ability of the investor.
On Characteristics of Investing Success
Most great investors stick to an approach through thick and thin, and yet every approach goes out of favor sometimes, which means that every investor has periods in the dog house. To be a great investor, you must have an approach, and you have to stick to it, despite the times when it’s not working.
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Waiting patiently is an essential part of being an investor. And when you do take action, do it dynamically, forcefully.
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One of the real keys is to keep your emotions under control. Everything in the environment conspires to make us do the wrong thing, to buy when things are going well and prices are high — and to sell when things are going poorly and prices are lower, which is the exact opposite of what we should do. But it all comes from emotion. We have to resist.
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We are all going to have times when we look wrong. My third great adage is being too far ahead of your time is indistinguishable from being wrong. You may do the right thing. It may take years to work. In that period you are going to look wrong if you are a contrarian and out of step, and yet this is how you must behave.
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If you buy something and it goes down, you have to reassess your thesis. And if it’s intact, you have to buy more or you can’t be great. But on the other hand, if you have hubris and you feel you can’t possibly be wrong and every time something goes down you blindly double down, then you’re probably going to get into trouble and maybe be asked to leave the industry. So, you have to have this balance, confidence but not overconfidence. Humility, but not over-humility.
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I believe strongly that success carries within itself the seeds of failure. And failure carries the seeds of success, what do you learn from success? I can do it. I can do it again. It’s easy. I can do it in other fields. I can do it with more money. I can do it alone. It was me; it wasn’t a team. And these are horrible lessons. So, I think that success teaches terrible lessons because it plays to our egos. And, you know, I think you learn more from your failures. And hopefully, you learn humility.
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I always say that to deal with the future, you need two things. Most people think you need one thing: a view of what’s going to happen. But I think you really need two things: a view of what’s going to happen, and a view of the probability that you’re right. We should accept the fact that some of our opinions have a higher probability of being right than others.
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What is it that will keep us from succumbing to the same mania that captures everybody else? The answer is we have to be objective. We have to be value-based. We have to be steadfast in our attention to the pendulum at the extremes.
On Smart Investing
There’s no asset so good that it can’t be overpriced and become a bad investment, and very few assets are so bad that they can’t be underpriced and be a good investment. People just don’t understand this. They say things like, “This is a great company, and you should buy the stock.” If it’s a great company, maybe you should buy the stock — but only at a good price.
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Returns are high when you can buy something for less than its real worth. When distressed debt investors produced high returns, it’s because they bought debt when a company’s problems were exaggerated and the price of its bonds fell too low. In other words, the distress was over-stated… Our mantra historically has been good company, bad balance sheet.
On Above-Average Returns
Investing is a funny business. It’s really easy to be average. Just buy an index fund. It’s really hard to be above average. But if you want to be above average, everything you do in the interest of being above average exposes you to the risk of being below average.
Sources:
Capturing Inefficiencies
The Human Side of Investing
Nobody Knows What Will Happen
Why Do So Many Investors Sell Out Too Early?
Why You May Be Your Own Worst Enemy as an Investor
Talks at GS
Graham & Doddsville
Surviving Market Storms
Related Reading:
Howard Marks: The “Negative Art” of Investing
Howard Marks Quotes
