I recently listened to a question-and-answer session with value investor Howard Marks (Trades, Portfolio) that piqued my interest and made me think about a number of questions relevant to retail investors. He was asked - in two separate questions - about whether he makes macro forecasts on the state of the market, and what he thinks about index funds. Although these two questions seem unrelated, they are actually closely related.
Forecasting
Marks was asked how he makes investments without making macro forecasts. He replied that while he likes to say he doesnât invest on the basis of macro forecasts, at the same time, he believes that:
âYou have to have an economic framework in mind when you predict the fortunes of individual companies. Itâs one thing to say âoil is at $50, and weâre going to invest in this company because itâll do fine if oil is at $50, survive if itâs at $30 and thrive at $70â. But itâs another thing to say âoil is at $50, I think that itâs going to $110, Iâm going to invest in this company thatâs going to do great if it goes to $110, but bankrupted if it stays at $50â. So the question is, how radical are your forecasts?â
Marks tries to anticipate a future that looks similar to what has happened in the past. In practical terms, this means investors need to look at current market conditions and compare them to historical averages. Trends tend to revert to the mean, so if something is more expensive today than it has been in the past, chances are it will become cheaper at some point in the future. Crucially, though, it is not possible to know exactly when it will become cheaper.
The role of index funds
Marks has often commented on the role of index funds, and whether they held reduce risk for the average investor. He thinks that a commonly-held belief about index funds is that they are low risk because they provide investors with exposure to a diversified portfolio of stocks. This is not strictly true. It is certainly the case that index funds protect investors against below-average returns, just as they preclude the possibility of earning more than the market average. But they do not eliminate, or even reduce, the risk of the market itself going down.
Arguably, this is why the oft-repeated adage that âitâs time in the market that counts, not timing the market,â needs to be taken with a large pinch of salt. Yes, itâs true that compound interest can seriously magnify a relatively small initial investment over time. Itâs also true that itâs very difficult (and arguably impossible) to time the ups and downs of the market.
But itâs also true that compound interest can only work its magic if you do not suffer drawdowns on your account. Investors who bought the S&P 500 at its then-all time highs in September 2008 learned this the hard way. Japanese investors who bought the Nikkei at all-time highs in 1991 are still waiting to make their money back (assuming they didnât cut their losses and sell).
Conclusion
The lesson for retail investors here is that while they should not try to forecast what will happen in a market over the next day, month or year, they need to be cognizant of market conditions and to have a sense for whether assets are cheap or expensive at any given point in time. Doing so will allow you to make the most of the capital that you have and to allow your wealth to compound efficiently. While you canât predict the future, you should learn to view it probabilistically and to judge whether or not the time is right for you to invest.
Read more here:
- When the Cure Is Worse Than the Disease
- Is It Really 'Different This Time?'
- The Investment Philosophy of David Einhorn
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
