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Stepan Lavrouk
Stepan Lavrouk
Articles (414) 

Howard Marks: You Can’t Predict, but You Can Prepare

It pays to be cautious when markets are expensive

March 24, 2020

You don’t spend more than half a century working in the financial markets without developing some kind of investment philosophy, and Howard Marks (Trades, Portfolio) certainly has a very interesting one. One of the great pleasures of covering financial news is getting to hear Marks talk about his approach to investing, risk management and everything else relating to his business. I was struck by something that he said in a recent interview concerning the difference between prediction and preparation. 

Always be prepared

Marks acknowledges that the coronavirus crisis was completely unforeseeable, but still thinks smart investors should have been prepared for some crisis:

“Certainly, everything happening today was unpredictable. Two months ago, most people couldn’t think about a catalyst that would bring about a recession or a correction in the markets. But I think the key is that even though we couldn’t predict the events we could prepare for them. That sounds like an oxymoron, but I think that when the markets are such as they were, two, six, twelve, thirty-six months ago, they are susceptible to an unpredictable black swan, and consequently that it was time to pull in our horns a little bit.”

The concept of Black Swans was of course popularized by trader and mathematician Nassim Nicholas Taleb. Simply put, a Black Swan is an unforeseeable event that fundamentally changes the world. Most readers are no doubt familiar with this phenomenon.

Taleb has also popularied the idea that systems exist along a spectrum of fragility, ranging from fragile (easily broken), robust (remains unchanged under stress) and antifragile (gain from stress). He posits that although it is impossible to predict exactly what will happen in the future (and, in fact, is very disdainful of people who claim to be able to do so), one can make reasonable assessments of whether or not a system is likely to break or gain under the stress of future crises.

Let’s apply this framework to markets. As I have written previously, markets were very expensively priced going into this crisis. In fact, based on the Schiller price-earnings ratio, they were more expensive only once before in recorded history: during the dotcom bubble of the late 1990s. These elevated valuations made stock prices extremely fragile to any exogenous shock.

Returning to what Marks said, we can extract a few key lessons.

First, remember that price is always important. There is no asset so wonderful that you should pay any price for it.

Second, be cognizant of what could happen, but never assume that you know what will happen. Getting too caught up in your own thesis and ignoring what the market is telling you is a surefire way to lose money.

And finally, always remember that when things get expensive, it is much better to hold back and have some cash or liquid assets on hand that will allow you to deploy capital when the pullback inevitably happens. Just ask Warren Buffett (Trades, Portfolio), who has chosen to sit on his more than $120 billion cash pile. Now that’s discipline.

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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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