The study of financial history is a study of cycles, of booms and of busts. Reliable economic and market data stretches back to the early 20th century, while anecdotal accounts of bubbles and manias can be found as early as the 17th. And yet time and time again, investors seem to make the same mistakes over and over. They are fearful when others are fearful, and greedy when others are greedy. In an appearance at the Hong Kong CFA Society, value investor Howard Marks (Trades, Portfolio) provided some thoughts as to why this might be.
A misunderstanding of risk and reward
Marks is a great believer in the idea that there is no asset so terrible that it can’t be good value, provided that the price is low enough. Consequently, for a distressed credit investor like his Oaktree Capital, periods of market panic are prime buying opportunities. Of course, there are often cheap bonds even during bull markets, but generally speaking there are fewer of them during good times.
Marks says that the majority of investors have the idea of risk and reward exactly backwards. They erroneously perceive expensive assets to be low risk and cheap assets to be high risk. Why is this? At the core of the matter is a belief in the wisdom of the crowd; in other words, that a stock is safe because everyone else thinks so.
However, this is a self-sustaining belief, relying on the psychology of the crowd rather than on the underlying fundamentals of the business in question. Indeed, a higher price is a marker of elevated, rather than decreased, risk, as the expected yield from investing in a more expensive stock will naturally be lower than if the price were lower. So people want to believe that those around them have done their due diligence, and trust in the wisdom of the crowd. On this, Marks said:
“Many people’s emotions fluctuate the same. We’re all subject to the same influences: we all read the same headlines, we all hear the same stories on TV, we all read the same economic reports. So the things that get other people excited and positive and optimistic about would tend to get us excited too. The things that bid securities up, those same forces, if permitted would make us [investors] excited and to buy when prices are high, and depressed and to sell when prices are low. So the point is: if your thinking and your emotion is the same as everybody else’s, then you cannot do the outthinking which is required to act against the herd”.
In other words, it’s not possible to be a contrarian without putting in the hard work and actually researching the businesses that you are invested in. Relying on the wisdom of others - who are themselves only relying on you to do your research - is a surefire way to become unmoored from economic reality.
Read more here:
- The Value Investor’s Handbook: Operating Leverage
- Warren Buffett: How Do Businesses Build an Economic Moat?
- The Value Investor’s Handbook: More Warning Signs to Look Out For
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