The Most Important Thing – by Howard Marks

Reading Time: 13 minutes

Summary by: Shuchi. P. Nahar

The efficient market hypothesis states that:

• There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed.

• Because of the collective efforts of these participants,information is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to

each other.

• Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.

• Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are “fair” relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no incremental return that is not related to (and compensatory for) incremental risk.

To me, an inefficient market is one that is marked by at least one (and probably, as a result, by all) of the following characteristics:

• Market prices are often wrong. Because access to information and the analysis thereof are highly imperfect, market prices are often far above or far below intrinsic values.

• The risk-adjusted return on one asset class can be far out of line with those of other asset classes. Because assets are often valued at other-than-fair prices, an asset class can deliver a risk-adjusted return that is significantly too high (a free lunch) or too low relative to other asset classes.

• Some investors can consistently outperform others. Because of the existence of (a) significant mis-valuations and (b) differences among participants in terms of skill, insight and information access, it is possible for mis-valuations to be identified and profited from with regularity.

This last point is very important in terms of what it does and does not mean. Inefficient markets do not necessarily give their participants generous returns. Rather, it’s my view that they provide the raw material mis-pricings that can allow some people to win and others to lose on the basis of differential skill.

Chapter : 3 Value

Warren Buffett says that the best investment course would teach just two things well: How to value an investment and how to think about market price movements. Step one starts right here.

The oldest rule in investing is also the simplest: “Buy low; sell high.” Seems blindingly obvious: Who would want to do anything else? But what does that rule actually mean? Again, obvious on the surface,it means that you should buy something at a low price and sell it at a high price. But what, in turn, does that mean? What’s high, and what’s low?

To simplify (or oversimplify), all approaches to investing in company securities can be divided into two basic types: those based on analysis of the company’s attributes, known as “fundamentals,” and those based on study of the price behavior of the securities themselves. In other words, an investor has two basic choices: gauge the security’s underlying intrinsic value and buy or sell when the price diverges from it, or base decisions purely on expectations regarding future price movements.

What is it that makes a security or the underlying company valuable? There are lots of candidates: financial resources, management, factories, retail outlets, patents, human resources, brand names, growth potential and, most of all, the ability to generate earnings and cash flow.

In fact, most analytical approaches would say that all those other characteristics financial resources, management, factories, retail outlets, patents, human resources, brand names and growth potential—

are valuable precisely because they can translate eventually into earnings and cash flow.

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.

Chapter : 4 The Relationship Between Price and Value

For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.

It’s a fundamental premise of the efficient market hypothesis and it makes perfect sense that if you buy something for its fair value, you can expect a return that is fair given the risk. But active investors aren’t in it for fair risk-adjusted returns; they want superior returns. (If you’ll be satisfied with fair returns, why not invest passively in an index fund and save a lot of trouble?) So buying something at its intrinsic value is no great shakes.

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And paying more than something’s worth is clearly a mistake; it takes a lot of hard work or a lot of luck to turn something bought at a too-high price into a successful investment.

What are the companies worth? Eventually, this is what it comes down to. It’s not enough to buy a share in a good idea, or even a good business. You must buy it at a reasonable (or, hopefully, a bargain) price.

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 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.

Chapter : 5 Understanding Risk

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. It’s not hard to find investments that might go up.
But you’re unlikely to succeed for long if you haven’t dealt explicitly with risk. The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it.
Why do I say risk assessment is such an essential element in the investment process? There are three powerful reasons.
First, risk is a bad thing, and most level-headed people want to avoid or minimize it. It is an underlying assumption in financial theory that people are naturally risk-averse, meaning they’d rather take less risk than more. Thus, for starters, an investor considering a given investment has to make judgments about how risky it is and whether he or she can live with the absolute quantum of risk.
Second, when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks.
Third, when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well. Was the return achieved in safe instruments or risky ones? In fixed income securities or stocks? In large, established companies or smaller, shakier ones? In liquid stocks and bonds or illiquid private placements? With help from leverage or without it? In a concentrated portfolio or a diversified one?

It is from the relationship between risk and return that arises the graphic representation that has become ubiquitous in the investment world . It shows a “capital market line” that slopes upward to

the right, indicating the positive relationship between risk and return. Markets set themselves up so that riskier assets appear to offer higher returns.

“Riskier investments provide higher returns. If you want to make more money, the answer is to take more risk.” But riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple: if riskier investments reliably produced higher returns, they wouldn’t be riskier!

Riskier investments are those for which the outcome is less certain. That is, the probability distribution of returns is wider. When priced fairly, riskier investments should entail:

• higher expected returns,

• the possibility of lower returns, and

• in some cases the possibility of losses.

Understanding uncertainty: Investing requires us to make decisions about the future. Usually we do so by assuming it will bear a resemblance to the past. But that’s far from saying outcomes will be distributed the same as always. Unusual and unlikely things can happen, and outcomes can occur in runs (and go to extremes) that are hard to predict. Underestimating uncertainty and its consequences is a big contributor to investor difficulty.

Chapter : 6 Recognizing Risk

Great investing requires both generating returns and controlling risk. And recognizing risk is an absolute prerequisite for controlling it.
Hopefully I’ve made clear what I think risk is (and isn’t). Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.

The next important step is to describe the process through which risk can be recognized for what it is.

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. High risk, in other words, comes primarily with high prices. Whether it be an individual security or other asset that is overrated and thus overpriced, or an entire market that’s been borne aloft by bullish sentiment and thus is sky-high, participating when prices are high rather than shying away is the main source of risk.

Like opportunities to make money, the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions. Regardless of what’s designed into market structures, risk will be low only if investors behave prudently.

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Chapter : 7 Controlling Risk

Outstanding investors, in my opinion, are distinguished at least as much for their ability to control risk as they are for generating return. High absolute return is much more recognizable and titillating than superior risk-adjusted performance.Since it’s hard to gauge risk and risk-adjusted performance (even after the fact), and since the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard. That’s especially true in good times.
But in my opinion, great investors are those who take risks that are less than commensurate with the returns they earn. They may produce moderate returns with low risk, or high returns with moderate risk. But achieving high returns with high risk means very little unless you can do it for many years, in which case that perceived “high risk” either wasn’t really high or was exceptionally well managed.
Bearing risk unknowingly can be a huge mistake, but it’s what those who buy the securities that are all the rage and most highly esteemed at a particular point in time to which “nothing bad can possibly happen” repeatedly do.

On the other hand, the intelligent acceptance of recognized risk for profit underlies some of the wisest, most profitable investments even though (or perhaps due to the fact that) most investors dismiss them as dangerous speculations.

When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.

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.

Chapter : 8 Being Attentive to Cycles

In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and “sure things” can fail. However, 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.
Very few things move in a straight line. There’s progress and then there’s deterioration. Things go well for a while and then poorly. Progress may be swift and then slow down. Deterioration may creep up gradually and then turn climactic. But the underlying principle is that things will wax and wane, grow and decline. The basic reason for the cyclicality in our world is the involvement of humans.

Mechanical things can go in a straight line. Time moves ahead continuously. So can a machine when it’s adequately powered. But processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

When people feel good about the way things are going and optimistic about the future, their behavior is strongly impacted. They spend more and save less. They borrow to increase their enjoyment or their profit potential, even though doing so makes their financial position more precarious (of course, concepts like precariousness are forgotten in optimistic times). And they become willing to pay more for current value or a piece of the future.

All of these things are capable of reversing in a second; one of my favorite cartoons features a TV commentator saying, “Everything that was good for the market yesterday is no good for it today.” The extremes of cycles result largely from people’s emotions and foibles, non objectivity
and inconsistency.

Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. They reverse (rather than going on forever) because trends create the reasons for their own reversal. Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.

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.

Chapter : 9 Awareness of the Pendulum
The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there.
Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that
it will move back toward the midpoint sooner or later.

In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.
Investment markets follow a pendulum-like swing:
• between euphoria and depression,
• between celebrating positive developments and obsessing
over negatives, and thus
• between overpriced and underpriced.
This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.”

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The occurrence of this pendulum-like pattern in most market phenomena is extremely dependable. But just like the oscillation of cycles, 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.
For a bullish phase to hold sway, the environment has to be characterized by greed, optimism, exuberance, confidence, credulity, daring, risk tolerance and aggressiveness.

But these traits will not govern a market forever. Eventually they will give way to fear, pessimism, prudence, uncertainty, skepticism, caution, risk aversion and reticence. Busts are the product of booms, and it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction.

There are a few things of which we can be sure, and this is one:
Extreme market behavior will reverse. Those who believe that the pendulum will move in one direction forever or reside at an extreme forever eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously.

Chapter : 10 Combating Negative Influences
Inefficiencies mispricings, misperceptions, mistakes that other people make provide potential opportunities for superior performance.
Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes.

Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions.
The first emotion that serves to undermine investors’ efforts is the desire for money, especially as it morphs into greed.

Most people invest to make money. (Some participate as an intellectual exercise or because it’s a good field in which to vent their competitiveness, but even they keep score in terms of money.
Money may not be everyone’s goal for its own sake, but it is everyone’s unit of account. People who don’t care about money generally don’t go into investing.)
There’s nothing wrong with trying to make money.

Indeed, the desire for gain is one of the most important elements in the workings of the market and the overall economy. The danger comes when it moves on further to greed.

Greed is an extremely powerful force. It’s strong enough to overcome common sense, risk aversion, prudence, 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.

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 they have become highly priced in the hope there’s still some appreciation left.

Afterwards, hindsight shows everyone what went wrong: that expectations were unrealistic and
risks were ignored.

To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored.

Doing these things isn’t easy, and thus few people are able to abstain. In just the same way, it’s essential that investors avoid selling and preferably should buy when fear becomes excessive in a crash.

This blog contains first half of the chapters that were covered in the book and rest half of the chapters will be in continuation in the coming blog.

Source: BOOK(THE MOST IMPORTANT THING -by howard marks)


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Shuchi Nahar

Shuchi Nahar

Shuchi is NISM Certified Equity Research Analyst, CFA - Level 1, a student of Law and Finance, and an aspiring CS.
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