16. The Most Important Thing Is… Appreciating the Role of Luck
Luck and chance are two things investors should cherish dearly when dealt a great hand. As we all know there is a difference between what may happen or has happened and the probability of it happening. A great example of this is when Warren Buffett went to speak to a manager of GEICO on a Saturday afternoon. It was closed and as chance had it, the one man in the building let him in and talked to him extensively about GEICO after Buffett had found out Ben Graham sat on the board of directors. This investment turned out to be the most successful of both Warren’s and Ben’s career. Or as Nassim Taleb talks about in “Alternative Histories,” that could have just of easily occurred as what actually did occur.
Nassim Taleb had said, “Clearly my way of judging matters is probabilistic in nature; it relies on the notion of what could have probably happened… If we have heard of [history’s great generals and investors], it is simply because they took considerable risks, along with thousands of others, and happened to win. They were intelligent, courageous, noble (at times), had the highest possible obtainable culture in their day – but do did thousands of others who live in the musty footnotes of history:”
Essentially, history’s spoils go to the winners in a take-all fashion, but it could have just as easily gone the other way.
Most often the luck is not re-creatable because it was just that, luck. Skill and luck are very different contrasts as illustrated in another one of Taleb's passages. “$10 million earned through Russian roulette does not have the same value as $10 million earned through diligent and artful practice of dentistry. They are the same, can buy the same goods, except that one’s dependence on randomness is greater than the other. To your accountant, though they would be identical… Yet, deep down, I cannot help but consider them as qualitatively different.”
We should analyze the probability of success when luck or randomness is involved and confer the likelihood of it happening again. As in poker, the quality of an investment decision is not governed by the outcome (monetary gain) but by the process in which the participant went through to reach his thesis.
17. The Most Important Thing Is… Investing Defensively
“There are old investors and there are bold investors, but there are no old bold investors.”
Investing defensively means exactly that, playing defense, minimizing error or risk, as appose to maximizing gains or reward. Howard uses a great metaphor in regards to a professional tennis players and the game they play relative to investors.
“So much is within the control of the professional tennis players that they should really go for winners. And they’d better, since if they serve up easy balls, their opponents will hit winners of their own and take points. In contrast, investments results are only partly within the investors’ control, and investors can make good money – and outlast their opponents—without trying tough shots. The bottom line is that even highly skilled investors can be guilty of miss-hits, and the overaggressive shot can easily lose them the match. Thus, defense—significant emphasis on keeping things from going wrong—is an important part of every investors game.”
Consistency is key in the realm of defense, routinely doing what is right while occasionally making new progress through flashes of offense, relative to investing, flashes of brilliant ideas. I use a simple (and probably over used) metaphor, instead of being focused on slugging percentage alone, you should be focused on the batting average and walked percentage in relation to home runs earned. It is the consistent singles, with an occasional "homer" that win the game. Everything in the capital markets is a two edged sword, as you attempt to take higher returns you are also willingly (and maybe unknowingly) taking more risk. There is no right or wrong, but trade-offs that must be made between risk and return, and the volatility that an investor may be able to stomach. Ensuring the ability to survive over the long-term is more important than short-term gains and a portfolio should be built to withstand a scenario of 2008-2009 or worse. Howard mentions in his book how brief most exceptional investment careers are, how competition is eroded by the sands of time and bad choices, and finally how many brilliant people struck out swinging for the fences (see Long-term Capital Management case studies). It is an unfortunate truth but directly related to Aesop’s parable of the tortoise and the hair. “Slow and steady wins the race.” Although the parable also brings focus to complacency, narcissism, and ego, I believe the root of the lesson to be centered on patience and persistence, much like long-term investment success. Investing scared is not something to be ashamed of but something to be emulated by all rational and intelligent investors. Knowing what you don’t know and can’t control are two very powerful things. As mentioned everything is a two edged sword and I would like to conclude this portion with a quote from what Howard calls his favorite fortune cookie.
“The cautious seldom err or write great poetry.”
18. The Most Important Thing Is… Avoiding Pitfalls
“An investor needs do very few things right as long as he avoids mistakes.” – Warren Buffett
Most investor pitfalls lay within A) incorrect or lack of information B) emotions/psychology and C) excessive fees and taxes. An investor who does not construct a portfolio with enough risk is forgoing returns, although no one that I have heard of has gone broke from that. Investing is an analytical process, weighing both tangibles and intangibles that may either be examined though both quantitative and qualitative measures.
Many of the errors based around emotions and psychology have been talked about in previous parts of the article, so I will not go in to depth about fear and greed. An investor must be flexible, allowing for unpredictable events to occur, and take outliers with a grain of salt. Living in a probability-driven world can drive a man mad due to the unpredictable factors of human nature, among many other variables. Acknowledging that some probabilities can’t be quantified and learning to accept and capitalize on unlikely events is one of the greatest tools a rational investor has. No imagination or a lack of it will also prove to be a hindrance to an investor seeking above-average returns, or as Sam Walton likes to call it: “Swimming up stream” will get you where others aren’t.
Howard Marks also states how investors are naïve or unaware to the correlation between asset classes held within a portfolio. Diversification proves to be unneeded or more likely unwanted if returns are reduced to mitigate loss, but in turn very little, if any losses are mitigated.
Marks also states three points in which investors are harmed by the forces of the market:
- By succumbing to them.
- By participating unknowingly in markets that have been distorted by others’ succumbing.
- By failing to take advantage when those distortions are present.
Some of the keys to success are the ability to observe, learn and adapt to changing tides while having a strong sense of confidence in ones research and/or self. Being patient and sitting on your hands is sometimes the best approach to finding investments, allowing the ideas to come to you. When an investor is doing research, he must calculate the numbers for himself, collecting information from primary resources, not secondary opinions. Using conservative estimates to form “ranges of outcomes” will also provide protection from mistakes in the analytical process.
|Common Mistakes of Investors||Fear||Greed|
|Not buying||Buying too much|
|Not buying enough||Buying too aggressively|
|Not making on more bid||Making one bid too many|
|Not using enough leverage||Using too much leverage|
|Not taking enough risk||Taking too much risk|
19. The Most Important Thing Is… Adding Value
When adding value one of the most accurate and efficient measurements regarding the risk-adjusted return may be the sharpe ratio. Calculating the excess return produced by alpha (the measurement of management performance) versus beta (the correlation to market volatility) may prove insightful to an investor seeking a talented fund manager. There is no way to know the full risk of a portfolio until hindsight is available and reflections may be made after the storm has passed. Managers or investors may simply take on more volatility in search of higher returns. Howard uses another simple yet brilliant two-by-two matrix to depict two very different investors [size=11.0pt;line-height:115%; font-family:"Calibri","sans-serif";mso-ascii-theme-font:minor-latin;mso-fareast-font-family: Calibri;mso-fareast-theme-font:minor-latin;mso-hansi-theme-font:minor-latin; mso-bidi-font-family:"Times New Roman";mso-bidi-theme-font:minor-bidi; mso-ansi-language:EN-US;mso-fareast-language:EN-US;mso-bidi-language:AR-SA">—
|Aggressive Investor||Defensive Investor|
|Without Skill||Gains a lot when the market goes up, and loses a lot when the market goes down.||Doesn’t lose much when the market goes down, but doesn’t gain much when the market goes up.|
|With Skill||Gains a lot when the market goes up, but doesn’t lose to the same degree when the market goes down.||Doesn’t lose much when the market goes down, but captures a fair bit of the gain when the market goes up.|
Comparing various benchmarks (apples to apples) over a given period of time (say five or 10 years) would most likely provide enough insight into a particular fund manager, if of course that is what you are looking for. Otherwise it may be used to evaluate oneself and ultimately make the decision to A) stay your course, B) find a new captain, or C) buy a passive index fund and hold on forever.
20. The Most Important Thing Is… Pulling It All Together
Pulling it all together refers to using the other 18 points (excluding adding value and putting it all together from the 20) in an efficient manner. I would advise re-reading the first three parts at this point followed by “The Most Important Thing” by Marks and finally Oaktree memos found throughout the article and on the Oaktree website.
The 20 Most Important Things Proposed By Howard Marks (Part I Of IV)
The 20 Most Important Things Proposed By Howard Marks (Part II Of IV)
The 20 Most Important Things Proposed By Howard Marks (Part III Of IV)
Also check out:
- Howard Marks Undervalued Stocks
- Howard Marks Top Growth Companies
- Howard Marks High Yield stocks, and
- Stocks that Howard Marks keeps buying
About the author:I am working towards the CPA & CFA designations, and would love to manage an investment partnership in the future. I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.
"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain