Howard Marks: The Human Side of Investing
People are risk averse. It’s one of the great fallacies that riskier assets get better returns. Truth is sometimes risk premium is appropriate. Sometimes it is inadequate and sometimes excessive. As you move up the risk, you move up the return. But in practice, Q2 of 2007, before crisis hit, it looked like this. Risk was low and return was little. In Q4 08, investors became highly risk averse. They demanded extremely high amounts of return. It was a great time to invest. Theory: since markets price assets fairly, if you buy at market prices you can expect a “fair” risk-adjusted return. Practice: Buying without discernment.
Theory: People want more of something at lower prices and less of it at higher prices. Practice: People tend to warm to investments as they rise and shun them when they fall. This is one of the biggest mistakes people make. We can take advantage of it.
Human failings: At Chicago they talk about efficient markets – markets that don’t make mistakes. We want to find things that are priced wrong. Most of mistakes come from human failures. Best way to understand, is by thinking of the pendulum. I write about the pendulum a lot. In 1991 my second memo was that, and I still think it’s the most important thing, along with 20 others. Pendulum always swings between optimism and pessimism. Risk aversion and tolerance. Buying too much and selling too much. And it will never stop. These things will never stop as long as people are involved in the markets.
So this fluctuation takes place. Where is the pendulum now? Macro is in favor now. Everyone wants to predict what political, euro, all these questions are about, which we can’t know anything. But we can know something about the operation of the pendulum. My mother used to talk about happy medium. I should balance fear and greed, optimism and pessimism. The happy medium is rarely seen. Usually the market is going to or just back from an extreme. It is a much better way to think of the market. It is caused by the errors of the herd. Again, profit opportunity.
Think about a bull market cycle. I use adages and quotes because people were wiser before I got here. In 1973 three stages of bull market: people believe things will get better, most believe it has gotten better, and third when everyone thinks things will stay good forever. You want to buy at first and sell at third.
It is very important that realize that there aren’t safe or risky things to buy. There aren’t safe or risky investment strategies. They are safe in phase one, and risky in phase three. The greatest of all is what the wise man does in the beginning the fool does in the end. Every trend eventually becomes overdone. Why? In beginning only wise man finds it, and it works. They see it and are attracted to it and until the last fool buys it at a high price and loses a lot of money. You have to be conscious of where we are in the cycle.
Other than buying securities one at a time, most important question is whether to be on offense or defense, or how much of each. That decision should be informed based on where we are based on three stages of bull market. Or bear market.
Bear market: stage one: few people realize things are overpriced and going to fall; stage two: most people believe they are falling; stage three: everyone thinks they are gong to fall forever and you’ll never make a dime. People then want out. Because they extrapolate and think things will only get worse. If you could only ask one question of every stock, it should be: how much optimism is there in the price? Do people love it or hate it? Want to buy things they hate and sell things they love and can only get better. The truth is somewhere in between.
Human Failings: Few people are able to act in a contrarian fashion relative to these market cycles. But it is essential…
Charlie Munger: “This stuff is not easy, and people who think it is are stupid.”
We must be contrarian, but I don’t want to suggest that it is easy.
Dave Swensen wrote a book about 14 years ago called “Pioneering Portfolio Management.” Great quote: “Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.” The things they’re doing appear to work for a while. You are going to look wrong and feel wrong.
Third favorite: being too far ahead of your time is indistinguishable from being wrong. And we all know what they feel like. And being wrong is not pleasant. And being able to hang on is very challenging.
In order for the extremes of bubbles and challenges to take place, investor memory has to fail. Galbraith: Contributing to… euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory.”
Memory, and the result prudence, always come out the lower when pitted against greed. When you see the devil on a guys shoulder, says you should buy it because you’ll get rich. The angel says don’t buy it, there are very good reasons not to. And the devil wins. Madoff investors engaged in willing suspension of belief. People fell for it.
Cyclical vs. anti-cyclical behavior. In typical upcycle, economic indicators doing well, increasing earnings, investor’s returns are good, assets appreciate, riskier approaches outperform, leverage adds to gains and the capital markets eagerly provide financing. What are the human effects of all these things? People become more enthusiastic. As things get higher, they want to buy more. This is not right. We must do the opposite. But again, it’s challenging.
Knowledge of the future: overestimating what you know about the future introduces great risk. I am not talking about making predictions of company earnings. Must figure out what companies will earn in the future, whether will be successful or unsuccessful. On micro level, that’s what I call trying to know the knowable. When you get into the macro, the economy, markets – it’s very difficult and overestimating can risk. I have more quotes on this than any other.
Nothing scary about saying I don’t know. Scary is saying I know and I’m wrong. After this meeting I have to drive to Lincoln. If I say I don’t know how to go, get a map, I use GPS, ask directions and go slowly. But if I think I know the way, I don’t ask directions and drive fast and if turns out I don’t know the way, I may end up in Trenton before I get to Lincoln. Not knowing something is not fatal to an investor. Very dangerous.
That led me to talk about people in the I know school vs. people in the I don’t know school. I wrote a memo on this. I know school: confident in its foreknowledge. I don’t know school is skeptical. Invests for one outcome, concentrate, lever heavily, target maximum gains: I know school. Target maximum gains. I don’t know, like myself, school: hedge against uncertainty, diversify, avoid or limit leverage, avoids losses. Avoiding losses is at least as important as achieving gains. If we avoid the lowers, the winners take care of themselves: Oaktree motto. For a stock portfolio the promised return on stocks is not high, to have a good outcome you have to have some good ones, not adequate to just avoid losers, but having high emphasis on avoiding losers is very important.
Most people think in terms of the average or the norm and ignore the outliers. Don’t give enough allowance. Single scenario investing – the difficulty of seeing future events as the range of possibilities. When people think of the future as one thing I get turned off. There is never one future. There are always many futures. L Roy Demptom: Risk means more things can happen than will happen. The variability of outcomes.
Must view the future at best as a range of possibilities. Smartest investors are who understand the probability.
Even when you know exactly the probability distribution, it’s different from saying you know what’s going to happen: if you take one thing away. Investing consists of one thing: dealing with the future. We decide how to invest our money based on what we think we will return, yet I feel the future is not knowable. We have to wrestle with this conundrum. That’s what the book is about.
Things that are supposed to happen fail all the time. Things that are improbable happen all the time. This tells us what dealing with the future is like.
I told you about my favorite adage. Wise man and third adage. Second adage: never forget the six foot tall man who drowned crossing the stream that was five feet deep on average. When people fixate on one outcome, they can be fatally wrong. Every time we go through a crash, we see the failure of investors and entities that were set up for good outcome. And it’s obvious in investing it’s not sufficient to survive on average, have to survive everything. Which means that we have to survive the worst case. Highly levered investors hit a bad patch, out, once they’re out they never get to recover. You never enjoy the recovery. Must survive on the bad days.
In particular (this slide focuses on black swans, the title of a book by Talib. First book called fooled by randomness. Oh lots of hands. I know I’m among friends. Your experience when you read it, most important badly written book you’ll ever read or… very challenging book. Deal with the world is uncertainty, future is a distribution of possibilities and randomness plays a great roll in which outcome happens.) Most investors ignore the possibility of extreme outcomes, so called black swans.”
What he called black swans I call the improbable disaster. The events of 08. Do you have lived through 08? Have your portfolio been set up so that if you lived through 08 you would do okay? By definition, if you say I must be prepared for a repeat of 08, you can never participate in the market. People talk about the worst case – well it can always get worse. Many who thought they prepared for the worst got played out. How much planning should you do for the worst case?
One of messages of Taleb is short term success and short term are imposters. Tell you very little about dependability of an investor. Rudyard Kipling knows twin imposters, success and failure. It is important not to fixate on short-term results. Given randomness in markets, tell you nothing about what’s really about the underlying process. I’ve seen people get famous for being right once in a row. If you think about randomness, in a system governed by randomness, anything can happen and anyone can be right in regard to anything. Can’t prove that person is a leader or genius or has a reliable process, the key word being reliable.
The twin imposters: non-appreciation of “alternative histories” the difficulty of seeing past events as the range of possible things that could have happened and thus the reduced significance of what actually did happen. I said in a memo, Amarant’s problems didn’t start in 06 when it melted down. Its problems started in 05 when it was up 100 percent. Most people don’t see their statement up 100% and say oh no, I’m screwed here, what is this person doing? They send in more. Market timing is much worse than buy and hold. You have to appreciate the alternative. What happened wasn’t important thing, but what could have happened.
Timing. The difficulty of getting timing right – “should” isn’t the same as “will.” It’s hard to do the right thing in the investing world, and impossible to do the right thing at the right time. No one should work under the assumption that they’re going to get the time right. If you have bet too much on what should happen happening right away, you could be in big trouble.
The pitfalls of investment bureaucracy: “active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel.” – David Swensen. Marriage is a wonderful institution, for people who like living in institutions.
Most institutions in my opinion expend effort for the purpose of avoiding embarrassment, and thus over diversify. We would never do enough of something so that if I made a mistake I would look wrong. But corollary is true too. That’s why investing in an institutional setting interferes with great investing. I once wrote a memo “dare to be great,” do you dare to be great? And if you do, you run the risk of being wrong and being embarrassed. You can’t have it both ways.
In many ways, the forces that influence investors push them toward mistakes: investing in things with obvious appeal, that are easily understood, that are popular, that have been doing well. All apply to the herd and imply elevated prices, limited return potential and substantial risk. Try to find the bargain among those, very very hard. Real bargain usually found in the things people will not do.
Imprudent, unwise, undesirable – that’s where you find the bargains.
What could be more unseemly than investing in bankrupt companies? Well guess what, you can find a lot of bargains there. We’ve never had a fund that didn’t make 10%.
Smart investing doesn’t consist of buying good things, but rather of buying things well. Price is what matters most for investment success.
To sum up: the efficient market hypothesis tells us that the market operates smoothly to incorporate information into prices, so that no individual can consistently do much better. In fact “inefficiencies” the investing crowd’s mistakes – arise all the time and are the superior investors raise d’etre.
At the extremes, when the actions of the crowd create bubbles and crises, the mistakes of others create…
Our approach has always been based on understanding and controlling risk, insistence on consistency, involvement in less-efficient markets only, high degree of investment specialization, no reliance on marco-economic projection, no raising of cash for purposes of market timing
The common thread running through the tenets of the philosophy is the recognition of and respect for the limitations imposed by real-world considerations.
Question: over the years, how do you continue to become a better investor, do you learn more from mistakes or successes?
What I have learned through time is to observe what’s going on around in terms of investor behavior and market and act accordingly. And to see the upward swing of the pendulum which carries so much enthusiasm as worrisome and the downward swing encouraging. Buffett favorite quote is the less prudence with which people conduct their affairs the greater prudence with which we should conduct ours. I’ve learned to do that.
Q: Specifically, what investments do you like most, as of today.
Specifically I’m not going to tell you [laughter]. But most things are in favor today. But in favor rarely gives you the best bargains, and things out of favor have bargains include shipping, Europe, real estate. US commercial real estate. Trouble is always the first person to think about it and neither have I, people are lined up. REITs are lined up for income. People exited bonds and looked elsewhere for yield and did REITs. Not a formula for success but a place to look.
Q: Not to put on spot, but on cycles couldn’t wait to read your next book, but what state of the cycle are we at?
People ask me a lot because after Lehman brothers people asked what are we in. Today we are probably in sixth or seventh inning. Think of the three stages of cycle, I think we’re not in the bottom third, not at cyclical peak in most asset classes, certainly not the stock market. Around the middle but if I had to say, above the midline. I put out a memo called “pros and cons of equities” and they are distributed on both sides of the equation. Profits are high, but margins are unsustainably high. Pe ratio is average but maybe should be below average because growth outlook is not as good for next 10 years as last 50 years. So both sides. Move forward but with caution.
Q: In fixed income world, view on analogy to 1994 and today and how Oaktree is positioned.
We’re investing in high yield bonds and least seedy thing we do [laughter]. Average high yield bond, if went up 200 basis points, even if interest rates rise, were at 2% a year. But we’re at the lowest interest rate in history. Can’t get much lower; they can get a lot higher.
When you rent a video some videos allow you to pick an ending. If you buy 10 year at 1.7%, which is the good ending? Answer is good investment ONLY if we have depression, inflation or calamity. All three are by definition hard to predict. Not impossible. But hard.
One of the things I always try to do is to try to figure out what is the available mistake today and don’t make it. Hard to figure out a stroke of genius, but help if you say what is the big mistake today, is probably long treasuries, or any treasuries at all. Jeff Gundblack had interesting insight to bond world: bond investor looks back at opps a year ago and wishes they had made those investments. And in a year. But, if not buying today is a mistake, hard to believe it’s a huge mistake. Might be a little mistake. Could you get out five years and say oh I really should have bought that 10-year at 1.7. I really don’t think anyone’s gonna slit their wrist over that.
Q: Good to buy when everyone is down and sell when up.
Japen in 1990 and us in early 30 and everything selling and if you buy you would lose a lot of money. In 88 Japan hit a high and everyone sell and would have lost money for next 22 years. How do you avoid that and the answer is – you can’t. there is no correct rule. There can’t be a rule that always works. Is true that if I say buy when people are selling there will be times that cause you to lose money. Nothing reliable to be said about making money, because if there were, study would be intense and everybody with a positive IQ would be rich.
Q: How square momentum strategies that outperform, there is work that supports that view.
A: I haven’t seen that work and I’m very strong in my believes so I probably wouldn’t read it. Probably a matter of time frame. Hard to believe that buying things that have gone up a lot is the best way to make money over 10 years. None of us can be successful in any activity if we don’t believe in it.