Today’s post is our third visit to The Most Important Thing by Howard Marks.
Chapter 9 of Marks’ book is about the oscillation of investor attitudes and behaviour.
We never know how far the pendulum will swing in its arc, what might cause the swing to stop and turn back, when this reversal will occur, or how far it will then swing in the opposite direction.
The pendulum spends very little time at the equilibrium point of its arc.
When it’s positioned at its greatest extreme, people increasingly describe that as having become a permanent condition.
But whenever it’s near an extreme, it must inevitably move back toward the midpoint at some point.
The swing back from the extreme is usually more rapid – takes much less time – than the swing to the extreme.
Some of the ways to characterise the arc include:
- euphoria to depression
- focusing on positives (optimism) to focusing on negatives (pessimism)
- overpriced to underpriced
- fear (risk aversion) to greed (risk tolerance)
- credulousness to scepticism
Marks particularly looks towards the level of risk aversion as the driver of bubbles and crashes.
The academics consider investors’ attitude toward risk a constant, but certainly it fluctuates greatly.
I’ve boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both.
In an ideal world, investors would balance these two concerns. But from time to time, at the extremes of the pendulum’s swing, one or the other predominates.
Marks has three stages to a bull market:
- When a few forward-looking people begin to believe things will get better
- When most investors realize improvement is actually taking place
- When everyone concludes things will get better forever
And three for a bear:
- When just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy
- When most investors recognize things are deteriorating
- When everyone’s convinced things can only get worse
Unless the financial world really does end, we’re likely to encounter the investment opportunities of a lifetime.
Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.
The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.
Marks covers a few psychological drivers, which we’ve discussed before:
- fear (panic)
- suspension of disbelief (dismissal of logic)
- seeking peer approval (running with the crowd)
- envy/comparison to others (keeping up with the Joneses)
- capitulation (fear of missing out)
The belief that some fundamental limiter is no longer valid – and thus historic notions of fair value no longer matter – is invariably at the core of every bubble and consequent crash.
There can be few fields of human endeavour in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present – JK Galbraith.
Incorrect, even imprudent, decisions to bear increased risk generally lead to the best returns in good times (and most times are good times). When things go right, it’s fun to feel smart and have others agree.
In contrast, thoughtful investors can toil in obscurity, achieving solid gains in the good years and losing less than others in the bad. Investing shouldn’t be about glamour, but often it is.
There’s no simple solution: no formula that will tell you when the market has gone to an irrational extreme, no foolproof tool that will keep you on the right side of these decisions, no magic pill that will protect you against destructive emotions. As Charlie Munger says, “It’s not supposed to be easy”.
In Chapter 11, Marks’ disdain for trend followers resurfaces.
Superior investing 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.
The trend, the consensus view, is something to game against.
I think that a lot of this disparity between contrarians and trend followers comes down to timing.
Marks would get out of a bubble early, on the way up.
- The problem with this is that you could be years too early.
I usually wait until the crash begins, and try to get out quickly.
- I also like to use many markets and many strategies, which means that they don’t usually all crash at once.
It’s not difficult to be contrarian these days.
The major cults include:
- tech stocks
- passive market-cap indexing
- equity income funds
- small cap home market growth stocks (AIM in our case in the UK)
- lottery tickets (biotech, mining and resources)
You can label most of this trend-following in some sense, but that doesn’t undermine the value of the technique as part of a diversified portfolio.
I would argue that most people only need to be contrarian (let’s say not passively indexing) with a relatively small proportion of their net worth (say 10% to 40%).
- Further, most people will not be psychologically suited to making big contrarian bets.
I have less issue with Marks’ contrarian advice to buy during a crash.
- I will merely note that if the crash is severe enough (as in 2009), this will be psychologically very hard to do.
And as Marks notes:
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.
You have to have a strategy for the normal to good times, too.
At the same time, Marks makes some good points:
Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.
There are two primary elements in superior investing: · seeing some quality that others don’t see or appreciate (and that isn’t reflected in the price), and · having it turn out to be true (or at least accepted by the market).
Which is not so straightforward.
Scepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.
But he comes back to the contrarian message:
It’s our job as contrarians to catch falling knives, hopefully with care and skill.
I think that task is beyond most investors.
In chapter 12, Marks describes the investment process of building a portfolio:
Buying the best investments, making room for them by selling lesser ones, and staying clear of the worst.
The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.
This is, of course, a stock-picking portfolio, not a risk parity portfolio.
Marks says that even the most sophisticated stock-pickers will rule out some things:
There can be risks with which certain investors aren’t comfortable – obsolescence in a fast-moving segment of technology, and the risk that a hot consumer product will lose its popularity.
Or industries [that] are too unpredictable or financial statements [that] aren’t sufficiently transparent.
The next step is to choose the best investments from the remaining set:
Whether prices are depressed or elevated, and whether prospective returns are therefore high or low, we have to find the best investments out there.
Since we can’t change the market, if we want to participate, our only option is to select the best from the possibilities that exist. These are relative decisions.
Superior usually means value for money, high return for the risk.
- So for Marks, it’s largely defined by price.
Our goal isn’t to find good assets, but good buys. It’s not what you buy; it’s what you pay for it. A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy.
So what makes a bargain?
Potential bargains usually display some objective defect. A company may be a laggard in its industry, a balance sheet may be over-levered.
Bargains are often created when investors either fail to consider an asset fairly, or fail to look beneath the surface to understand it thoroughly or fail to overcome some non-value-based tradition, bias or stricture.
The necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do.
Marks gives as examples – of bargain asset classes that he has personal experience with – convertible securities and junk bonds (in the 1970s) and distressed debt (in the 1980s).
It’s been another entertaining read, but the themes of the book are by this point starting to repeat in every chapter.
- While Marks’ analysis of how markets operate is compelling – and he remains very quotable – strategies for taking advantage (that can be employed by the average investor) are thin on the ground.
I’m not (exclusively) a value and contrarian investor, not am I primarily a stock-picker.
- Marks appears to be all three, and as such his religious fervour on these approaches seems overdone to me.
Until next time.
Article credit to: https://the7circles.uk/the-most-important-thing-3-psychology-and-contrarianism/