The Most Important Thing by Howard Marks

• The most important things are:
• Second-level thinking
• Understanding market efficiency (and its limitations)
• Value
• The relationship between price and value
• Understanding risk
• Recognizing risk
• Controlling risk
• Being attentive to cycles
• Awareness of the pendulum
• Combating negative influences
• Contrarianism
• Finding bargains
• Patient opportunism
• Knowing what you don’t know
• Having a send for where we stand
• Appreciating the role of luck
• Investing defensively
• Avoiding pitfalls
• Adding value
• Pulling it all together
• No rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly. Psychology plays  a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable. An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness.
• First-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. Be definition, this can’t be the route to superior results. All investors can’t beat the market since, collectively, they are the market.
• The problem is that extraordinary performance comes only from correct non consensus forecasts, but non consensus forecasts are hard to make, hard to make correctly and hard to act on.
• You can’t do the same things others do and expect to outperform.
• Unconventionality shouldn't be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently.
• To achieve superior investment results, you have to hold non consensus views regarding value, and they have to be accurate. That’s not easy.
• For your performance to diverge from the norm, your expectations--and thus your portfolio--have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking.
• To beat the market you must hold an idiosyncratic, or noncensus, view.
• The [mutual fund] ratings don’t say anything about their having beaten an objective standard such as a market index.
• A market characterized by mistakes and mispricings can be beaten be people with rare insight. Thus, the existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it. It does not, however, guarantee it.
• For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without out, any hope for consistent success as an investor is just that: hope.
• The oldest rule in investing is also the simplest: “Buy low; sell high”.
• On a superficial level, you can take it to mean that the goal is to buy something for less than you sell it. But since your sale will take place well down the road, that’s not much help in figuring out the proper price at which to buy today. There has to be some objective standard for “high” and “low”, and most usefully that standard is the asset’s intrinsic value. Now the meaning of the saying becomes clear: buy at a price below intrinsic value, and sell at a higher price.
• In a nutshell, value investors aim to come up with a security’s current intrinsic value and buy when the price is lower and growth investors try to find security whose value will increase rapidly in the future.
• Value investors buy stocks (even those whose intrinsic value may show little growth in the future) out of conviction that the current value is high relative to the current price.
• Growth investors buy stocks (even those whose current value is low relative to their current price) because they believe the value will grow fast enough in the future to produce substantial appreciation.
• Chances to buy well below actual value don’t come along every day, and you should welcome them. Warren Buffett describes them as “buying dollars for fifty cents”. So you buy it and you feel you’ve done a good thing. But don’t expect immediate success. In fact, you’ll often find that you’ve bought in the midst of a decline that continues. Pretty soon you’ll be looking at losses. And as one of the greatest investment adages reminds us, “Being too far ahead of your time is indistinguishable from being wrong”.
• Investment success doesn’t come from “buying good things,” but from “buying things well”.
• You can’t make a career out of buying from forced sellers and selling to forced buyers; they’re not around all the time, just on rare occasions at the extremes of crises and bubbles.
• Since buying from a forced seller is the best thing in our world, being a forced seller is the worst. That means it’s essential to arrange your affairs so you’ll be able to hold on--and not sell--at the worst of times. This requires both long-term capital and strong psychological resources.
• Trying to buy below value isn’t infallible, but it’s the best chance we have.
• Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable. Thus, dealing with risk is an essential--I think the essential--element in investing.
• Here’s the key to understanding risk: it’s largely a matter of opinion. It’s hard to be definitive about risk, even after the fact.
• Investment risk is largely invisible before the fact--except perhaps to people with unusual insight--and even after an investment has been exited. Fro this reason, many of the great financial disasters we’ve seen have been failures to foresee and manage risk.
• Risk exists only in the future, and it’s impossible to know for sure what the future holds...No ambiguity is evident when we view the past.
• Projections tend to cluster around historic norms and call for only small changes...The point is, people usually expect the future to be like the past and underestimate the potential for change.
• People overestimate their ability to gauge risk and understand mechanisms they’ve never before seen in operation. In theory, one thing that distinguishes humans from other species is that we can figure out that something’s dangerous without experiencing it.
• Great investing requires both generating returns and controlling risk. And recognizing risk is an absolute prerequisite for controlling it.
• Recognizing risk often starts with understanding when investors are paying it too little heed, being too optimistic and paying too much for a given asset as a result.
• Risk arises when markets go so high that prices imply losses rather than the potential rewards they should. Dealing with this risk starts with recognizing it.
• The risk-is-gone myth is one of the most dangerous sources of risk, and a major contributor to any bubble. At the extreme of the pendulum’s upswing, the belief that risk is low and that the investment in question is sure to produce profits intoxicates the herd and causes its members to forget caution, worry and fear of loss, and instead to obsess about the risk of missing opportunity.
• Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion.
• In all aspects of our lives, we base our decisions on what we think will probably happen. And, in turn, we base that to a great extent on what usually happened in the past. [...] We tend to forget about the potential for outliers.
• Risk control is the best route to loss avoidance. Risk avoidance, on the other had, is likely to lead to return avoidance as well.
• The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.
• I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.
• There are two concepts we can hold to with confidence:
• Rule number one: most things will prove to be cyclical.
• Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.
• The longer I’m involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself.
• Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever, and investments that are outperforming will outperform forever, and vice versa. Instead, it’s the opposite that’s more likely to be true.
• Risk aversion is the essential ingredient in a rational market, as I said before, and the position of the pendulum with regard to it is particularly important. Improper amounts of risk aversion are key contributors to the market excesses of bubble and crash.
• It’s an oversimplification--but not a grievous one--to say the inevitable hallmark of bubbles is a dearth of risk aversion.
• Stocks are cheapest when everything looks grim. The depressing outlook keeps them there, and only a few astute and daring bargain hunters are willing to take new positions.
• Inefficiencies--mispricings, misperceptions, mistakes that other people make--provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistently outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes.
• Many people posses the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology.
• The counterpart of greed is fear--the second psychological factor we must consider. IN the investment world the term doesn’t mean logical, sensible risk aversion. Rather, fear--like greed--connotes excess. Fear, then, is more like panic. Fear is overdone concern that prevents investors for taking constructive action when they should.
• Greed is an extremely powerful force. It’s strong enough to overcome common sense, risk aversion, produce, caution, logic, memory of painful past lessons, resolve, trepidation and all the other elements that might otherwise keep investors out of trouble. Instead, from time to time greed drives investors to throw in their lot with the crowd in pursuit of profit, and eventually they pay the price.
• There’s only one way to describe most investors: trend followers. Superior investors are the exact opposite. Superior investing, as I hope I’ve convinced you by now, requires second-level thinking--a way of thinking that’s different from that of others, more complex and more insightful. By definition, most of the crowd can’t share it. Thus, the judgements of the crowd can’t hold the key to success.
• “Buy low; sell high” is the time-honored dictum, but investors who are swept up in market cycles too often do just eh opposite. The proper response lies in contrarian behavior: buy when they hate ‘em, and sell when they love ‘em.
• “Once-in-a-lifetime” market extremes seem to occur once every decade or so--not often enough for an investor to build a career around capitalizing on them. But attempting to do so should be an important component of any investor’s approach.
• You must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong. Only then will you be able to hold firmly to your views and perhaps buy more as your positions take on the appearance of mistakes and as losses accrue rather than gains.
• The ultimately most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high). These actions are lonely and, as Swensen says, uncomfortable. How can we know it’s the opposite--the consensus action--that’s the comfortable one? Because most people are doing it.
• The best opportunities are usually found among things most others won’t do.
• Since bargains provide value at unreasonably low prices--and thus unusual ratios of return to risk--they represent the Holy Grail for investors. Such deals shouldn’t exist in an efficient market for the reasons specified in chapter 2. However, everything in my experience tells me that while bargains aren’t the rule, the forces that are supposed to eliminate them often fail to do so.
• So here’s a tip: You’ll do better if you wait for investments to come to you rather than go chasing after them. You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own. An opportunist buys things because they’re offered at bargain prices. There’s nothing special about buying when prices aren’t low.
• One of the great things about investing is that the only real penalty is for making losing investments. There’s no penalty for omitting losing investments, of course, just rewards. And even for missing a few winners, the penalty is bearable.
• You simply cannot create investment opportunities when they’re not there. The dumbest thing you can do is to insist on perpetuating high returns--and give back your profits in the process. If it’s not there, hoping won’t make it so.
• The key during a crisis is to be (a) insulated from the forces that require selling and (b) positioned to be a buyer instead. To satisfy those criteria, an investor needs the following things: staunch reliance on value, little or no use of leverage, long-term capital and a strong stomach. Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.
• The important thing in forecasting isn’t getting it right once. The important thing is getting it right consistently.
• Overestimating what you’re capable of knowing or doing can be extremely dangerous--in brain surgery, transocean racing or investing. Acknowledging the boundaries of what you can know--and working within those limits rather than venturing beyond--can give you a great advantage.
• Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill.
• In the short run, a great deal of investment success can result from just being in the right place at the right time. I always say the keys to profit are aggressiveness, timing and skill, and someone who has enough aggressiveness at the right time doesn’t need much skill.
• The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people access it. A good decisions is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa.
• Randomness alone can produce just about any outcome in the short run. In portfolios that are allowed to reflect them fully, market movements can easily swamp the skillfulness of the manager (or lack thereof). But certainly market movements cannot be credited to the manager (unless he or she is the rare market timer who’s capable of getting it right repeatedly).
• A good decision is one that a logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known.
• There are old inventors, and there are bold investors, but there are no old bold investors.
• Few people (if any) have the ability to switch tactics to match market conditions on a timely basis. So investors should commit to an approach--hopefully one that will serve them through a variety of scenarios.
• A conscious balance must be struck between striving for return and limiting risk--between offense and defense. In fixed income, where I got my start as a portfolio manager, returns are limited and the manager’s greatest contribution comes through the avoidance of loss. Because the upside is truly “fixed”, the only variability is one the downside, and avoiding it holds the key. Thus, distinguishing yourself as a bond investor isn’t a matter of which paying bonds you hold, but largely of what you’re able to exclude bonds that don’t pay.
• One of the most striking things I’ve noted over the last thirty-five years is how brief most outstanding investment careers are. Not as short as the careers of professional athletes, but shorter than they should be in a physically nondestructive vocation.
• Operating a high-risk portfolio is like performing on the high wire without a net. The payoff for success may be high and bring oohs and aahs. But those slip ups will kill you.
• An investor needs do very few things right as long as he avoids big mistakes.
• A portfolio that contains too little risk can make you underperform in a bull market, but no one ever went bust from that; there are far worse fates.
• The power of herd psychology to compel conformity and capitulation is nearly irresistible, making it essential that investors resist them.
• There’s another important aspect of failure of imagination. Everyone knows assets have prospective returns and risks, and they’re possible to guess at. But few people understand asset correlation: how one asset will react to a change in another, or that two assets will react similarly to a change in a third. Understanding and anticipating the power of correlation--and thus the limitations of diversification--is a principal aspect of risk control and portfolio management, but it’s very hard to accomplish. The failure to correctly anticipate co-movement within a portfolio is a critical source of investment error.
• When greed goes to excess, security prices tend to be too high. That makes prospective return low and risk high. The assets in question represent mistakes waiting to produce loss...or to be taken advantage of.
• The essential first step in avoiding pitfalls consists of being on the lookout for them. The combination of greed and optimism repeatedly leads people to pursue strategies they hope will produce high returns without high risk; pay elevated prices for securities that are in vogue; and hold things after the have become highly priced in the hope there’s still some appreciation left. Afterwards, hindsight shows everyone what went wrong: the expectations were unrealistic and risks were ignored. But learning about pitfalls through painful experience is of only limited help. The key is to try to anticipate them.
• What we learn from a crisis--or ought to:
• Too much capital availability makes money flow to the wrong places.
• When capital goes where it shouldn’t, bad things happen.
• When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error.
• Widespread disregard for risk creates great risk.
• Inadequate due diligence leads to investment losses.
• In heady times, capital is devoted to innovative investments, many of which fail the test of time.
• Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem.
• Psychological and technical factors can swamp fundamentals.
• Markets change, invalidating models.
• Leverage magnifies outcomes but doesn’t add value.
• Excesses correct.
• The best defense against loss is thorough, insightful analysis and instance on what Warren Buffett calls “margin for error”. But in hot markets, people worry about missing out, not about losing money, and time-consuming, skeptical analysis becomes the province of old fogeys.
• Everything in investing is a two-edged sword and operates symmetrically, with the exception of superior skill. Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek. Superior skill is the prerequisite for it.
• You must have a good idea of what the thing you’re considering buying is worth. There are many components to this and many ways to look at it. To oversimplify, there’s cash on the books and the value of the tangible assets; the ability of the company or asset to generate cash; and the potential for these things to increase.
• To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them--ideally, all three.
• The relationship between price and value holds the ultimate key to investment success. Buying below value is the most dependable route to profit. Paying above value rarely works out as well.
• The superior investor never forgets that the goal is to find good buys, not good assets.