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Stepan Lavrouk
Stepan Lavrouk
Articles (422) 

Howard Marks: This Is the Essential Investing Subject

It’s not generally taught in business schools

March 20, 2020

There are many skills that successful investors need to have. They need to be able to read the language of accounting, in which is written the history of every company. They need to have a good understanding of risk/reward. They need to have conviction in their investments. They need to understand psychology. This last requirement was addressed by Howard Marks (Trades, Portfolio) in an interview.

Marks pointed out that if you go back and look at the graph of the economy for the last 50 years, it’s pretty steady. It’s got an upward trend, and very modest divergence from that trend. Sometimes the trend is a 2% line, sometimes it’s up 3% and sometimes it's up 1%. In extremes, it can be up 4% or down 2%, with very modest volatility overall.

Company results, on the other hand, are much more volatile due to the existence of financial and operating leverage. This means that they tend to do much better than the overall economy when it is growing, and much worse when it is contracting. In short, the graph of profits is more volatile than the graph of the economy, and the graph of the stock market is much more volatile than the graph of the economy because investors try to forecast future cash flows based on what they see happening in the here and now. After all, we are emotional beings. Marks referenced physicist Richard Feynman to make this point:

“Richard Feynman once said that physics would be a lot harder if electrons had feelings. We walk in the room, we turn on the light switch, the lights go on - every time! We don’t even wonder about it. The electrons never go on strike, they never forget to move, they always do what they’re supposed to do. But people have feelings, and rarely do what they’re supposed to do, and they often react in the extreme to the events that develop. And those extreme reactions cause extreme volatility...

If you want to exist in the investment world, you can just buy and hold good things if you want to take that approach. But if you want to improve upon that I think it’s very important to understand the ebb and flow of psychology and act accordingly”.

Note that this does not mean "try to time the market." No one can accurately forecast when the market is going to hit the top or the bottom, but what investors can do is make sure that they are buying when human psychology forces prices down. Note also that this does not mean that all sellers are irrationally panicking - when price drop, there are cases when they never recover.

There is a common criticism of the “buy when everyone is fearful” argument, and it roughly goes like this: “do you really think that all these people are panicking foolishly and that you are the only smart one?”

In fact, a lot of the time, the selling is driven by levered investors having to liquidate positions to put up more margin, rather than some mass delusion. We saw this earlier in the week when traditionally "safe haven" assets like Treasury bonds sold off sharply as investors raced to get more liquid. It only takes a relatively small segment of the market to begin panicking for a mass sell-off to begin. Psychology is the spark that can light the fire.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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anna91
Anna91 - 1 week ago    Report SPAM

I read this article! I hope you will continue to have such articles to share with everyone! thank you!

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