In chapter one of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor,” Howard Marks (Trades, Portfolio) carefully made a case for what he called “second-level thinking.” That refers to “deep, complex and convoluted” thinking and analysis of stocks, rather than “first-level thinking,” which he described as “simplistic and superficial.”
Next, in chapter two, he addressed an issue that challenges the very notion of second-level thinking: The efficient market hypothesis. It is one of the ideas that emerged from the Graduate School of Business at the University of Chicago in the 1960s (Marks was a student there from 1967 to 1969).
According to the author, the efficient market hypothesis comprises several premises:
- The market contains many participants who have generally the same access to all relevant information. They are also roughly equal in their objectivity, knowledge, intelligence and motivations.
- Their collective actions produce information that is fully and immediately reflected in the market price of each asset (an asset such as a stock, for example). In addition, whenever an asset becomes too cheap, it will be bought and when an asset becomes overpriced, it will be sold.
- As a result, market prices are realistic estimates of each asset’s intrinsic value and, therefore, no investor can consistently profit from occasions when prices are incorrect.
- Since all assets sell at “fair” prices, they can be expected to deliver comparable risk-adjusted returns. Put another way, investors seeking higher returns must take on greater risk.
Most value investors will have issues with the hypothesis. Marks pointed out that Yahoo was priced at $237 in January 2000, then, 15 months later, it was priced at $11. Obviously, it could not have been fairly priced in both instances, at least within the context of its fundamentals.
The market could not have been right both times. He reiterated a point made in the previous chapter: “If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or nonconsensus, view.”
He also linked the hypothesis to the development of passive vehicles, index funds. They make perfect sense within that context because if no one can beat the market, then why try. By using index funds, investors can earn the market return without transaction costs and management fees.
But his biggest beef with the hypothesis is in the way it links risk and returns, assuming humans are risk-averse by nature and will demand higher returns to take on higher risks. Thus, markets automatically adjust prices to match riskier assets with higher returns.
Further, the hypothesis arrives at the conclusion there is no such thing as investing skill, or “alpha,” which is logical in that context because everyone is expected to attain the same results. All investors know this idea is at least partially incorrect because some investors earn more than the market average and some earn less.
Marks concedes there are periods when riskier assets do deliver higher returns, but those happy periods “lull” investors into thinking all they have to do is take on more risk to get more rewards.
Such expectations can be troublesome since “they ignore something that is easily forgotten in good times: this can’t be true, because if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.”
Wrapping up his discussion of the efficient market hypothesis, Marks posed the question:“Is the market unbeatable?” By extension, are people who try to set out to beat the market doomed to failure? Are the investors who pay investment managers for active trading wasting their money?
While many of us who are value investors would likely disagree with the notion the market is unbeatable, the author takes a more nuanced position. He wrote, “As with most other things in my world, the answers aren’t simple … and they’re certainly not yes or no.” It should not be dismissed out of hand.
Second-level thinkers believe the markets are not entirely efficient, which is to say there are some “inefficiencies,” and those inefficiencies lead to pricing mistakes. Where do such inefficiencies or mistakes come from? Marks has some ideas:
- Among the assumptions of believers in the hypothesis is the idea all investors are objective. That, we know, is not true and, in fact, a large body of facts and knowledge has built up in the field of behavioral finance. Emotions are very prevalent; Warren Buffett (Trades, Portfolio) famously urged us to “Be fearful when others are greedy and greedy when others are fearful.”
- Another assumption among believers is investors are open to all types of assets, as well as being equally open to owning and short selling. Yet, there is a very lopsided balance between owners and short sellers. And few investors get to asset classes beyond stocks and bonds.
He added, “A market characterized by mistakes and mispricings can be beaten by people with rare insight. Thus, the existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it. It does not, however, guarantee it.”
Because mispricings do exist, investors who have above-average skills, insights and access to information should be able to consistently outperform other investors. In other words, those who apply second-level expertise should consistently do better than those who apply only first-level knowledge and skills.
Ultimately, Marks refused to come down on either side of the efficient markets debate, saying he believed there was some truth on both sides. And he drew one practical idea that has helped define him as a guru investor: “The key turning point in my investment management career came when I concluded that because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.”
In the end, he reconciled his belief in efficient markets with his belief that mispricing does occur and properly prepared investors can take advantage of those mistakes to earn above-average returns.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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