Howard Marks (Trades, Portfolio) most recent memo, “Dare to Be Great II”, is a fantastic read (here). As seems to happen often with Howard’s memos, I found myself plodding through much of his commentary thinking “well that’s common sense” – yet by the end, I felt as if I’ve learned something profound that I had not fully understood or pieced together beforehand.
I’m not entirely sure why that’s the case, but I think this particularly memo offers some insight into why that might be. On the fourth page, under the section titled “Dare To Be Wrong,” Howard discusses the two-edged sword that applies to many aspects of superior investing:
If you invest, you will lose money if the market declines.
If you don’t invest, you will miss out on gains if the market rises.
Market timing will add value if it can be done right.
Buy-and-hold will produce better results if timing can’t be done right.
Aggressiveness will help when the market rises but hurt when it falls.
Defensiveness will help when the market falls but hurt when it rises.
If you concentrate your portfolio, your mistakes will kill you.
If you diversify, the payoff from your success will be diminished.
If you employ leverage, your successes will be magnified.
If you employ leverage, your mistakes will be magnified.
I think that thought process may partially explain why Howard’s memos are so profound: He takes a holistic view of the world, as compared to “truths” we hear about in the investment community that often prove inadequate or flat-out wrong on closer inspection.
For example, let’s examine the fourth set of statements presented above:
If you concentrate your portfolio, your mistakes will kill you.
If you diversify, the payoff from your success will be diminished.
Now, that is certainly at odds with “conventional” thought: We all know that you must diversify in order to spread your risk and avoid putting all your eggs in one – or more accurately, too few – baskets. The first statement captures that thought process. But it’s not too often you hear someone discussing the merits of concentration; in my experience, they’re a rare breed.
For many, the answer is diversification or bust.
This has led to a truly nonsensical outcome. Many individuals will hold 50 or more stocks in their portfolio, spreading their risk across many geographic regions, industries and companies. In my view, they mistakenly act in line with conventional wisdom: diversification equals risk minimization.
Howard’s holistic approach should come in at this point: What is the trade-off from running such a diversified portfolio? As we can see above, each action we make (or fail to make) comes at a cost; what are we losing as we diversify? First off, it’s hard to add much to your portfolio when each position is but a small sliver of the overall pie. If you see something that other market participants have overlooked, and profit from that insight, a 1% position won’t do much for you.
In addition, it’s difficult to commit to thoroughly analyzing an endless number of companies. With one hundred different holdings, you’re looking at 300 10-Qs, another 100 10-Ks, countless 8-Ks, and other research material (trade magazines, investor events, etc.) a year. That’s a serious time commitment, even for a full time investor – all before considering any new ideas you might be interested in adding to your portfolio (as well as their competitors, etc).
I think the conventional wisdom has concluded that diversification is a significantly important part of sound investing – without putting any constraints on that diversification or discussing the trade-offs associated with doing so. In Howard’s memos, I think he has a tendency to highlight the trade-off between two different approaches; the consideration of the pros and cons for each approach forms the basis upon which sound decision making is based.
In the case of “Dare to Be Great II,” Howard shows that for some market participants – in this case institutional investors – this approach to trade-offs is distorted by an outside factor:
“I’m convinced that for many institutional investment organizations the operative rule –intentional or unconscious – is this: ‘We would never buy so much of something that if it doesn’t work, we’ll look bad.’ For many agents and their organizations, the realities of life mandate such a rule. But people who follow this rule must understand that by definition it will keep them from buying enough of something that works for it to make much of a difference for the better.”
Later in the memo, Howard ties back to that statement:
“Given the typical agent’s asymmetrical payoff table, the rule for institutional investors underlined above is far from nonsensical. But if it is adopted, this should be done with awareness of the likely result: over-diversification.”
This is the beauty of Howard’s memo in my eyes: The inability of institutional investors to make outsized bets, particularly among the unloved or unfollowed stocks, for fear of career risk or standing out from the herd, results in a scenario where they will largely over diversify and build a portfolio that looks much like their benchmark. The choice between concentration or diversification is largely predetermined for these participants; choosing the former would leave one open to outsized risks (fear of job loss, embarrassment, etc.), while the latter offers limited or even zero upside (as Howard notes, you might get an “attaboy” – and that’s about it). In this situation, herding is sure to follow.
But here’s the rub – and there’s no way around it: You can’t attain different results by doing the same thing as everybody else. We are left with a choice: accept results that are identical to the market (in which case our goal should be cost minimization), or pursue an approach in which we attempt to perform differently than others – in which case we must bear the risk of doing so.
Howard puts it perfectly: “Unconventional behavior is the only road to superior investment results.” Of course, it’s also the road that can lead to material underperformance if you don’t know what you’re doing.
We must actively make the choice. Are you going to take an active or a passive investment approach? If active, what will you be willing to do that’s different from the herd, and why do you presume it will be successful over time? If you find positions that meet your criteria, why are you only comfortable putting 1% of your chips on the table? Is your lack of concentration a representation of your lack of conviction – and if it is, why invest in the company at all? These questions require serious thought; answering them will go a long way in setting an appropriate strategy for yourself and sticking to it for the long term.
From what I see, many investors try and straddle the line: they pick individual stocks, but diversify to high heaven, largely because they have a lack of conviction about their abilities.
If they’re willing to admit that to themselves, there’s a logical question to follow: why not save much time (and potentially money) and invest through index funds? For many people, the answer’s probably that they should.
Howard’s memos consistently hit on what the active / passive decision entails: considering the trade-offs made in investing. Howard take the extra step, pointing to where people or institutions get tripped up by poorly thought out strategies or are constrained by either exogenous factors (career risk is a common one). The question is always the same: what is its impact? Many times, it is nearly insurmountable – a fly in the ointment that impairs the whole in a material way.
Sometimes simple truths – “you can’t take the same actions as everyone else and expect to outperform” – can capture profound ideas that are the cornerstone of intelligent investing.
