Normally, we would not associate luck and value investing, but in chapter 16 of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor,” Howard Marks (Trades, Portfolio) made an interesting case for doing so.
By understanding the relationship between luck and outcomes, Marks highlighted the importance of broad value investing principles.
To begin, he argued we should not see the investing universe as an “orderly and logical place” where specific actions lead to specific results. Whether we refer to “luck,” “chance” or “randomness,” there is more to investing outcomes than good decisions as “a great deal of the success of everything we do as investors will be heavily influenced by the roll of the dice.”
In making his case, he refers frequently to the book, “Fooled by Randomness” by Nassim Nicholas Taleb. As the title suggests, this book explores the large and unappreciated role of chance in local and world affairs. He also wrote “The Black Swan: The Impact of the Highly Improbable,” which refers to events that are rare but have a huge impact when they do occur.
Marks invited readers to examine a table from Taleb’s book, a table in which things on the left, such as luck, can be confused with things on the right, such as skill:
The upshot, according to Marks, is much of the investment success we experience and see is simply the result of being in the right place at the right time. For example, in bull markets, the biggest returns often end up with those who took the most risk, not those who were the best investors. The flip side is true as well: that the worst returns weren’t necessarily incurred by the worst investors.
Taleb also introduced Marks to the idea of “alternative histories,” which are other ways that the past might have worked out. This idea is important for investors because most of us tend to take the past as a fixed history. Yet, would recent history have been different if Steve Jobs and Steve Wozniak never met? Would there be an Apple Inc. (AAPL, Financial) if Wozniak had not been expelled from the University of Colorado?
The author reported he has remembered well one of his first lessons at university: that the quality of a decision is not to be measured by the outcome. A good decision is one that a “logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known.”
That means the factors affecting the correctness of a decision can’t be known in advance, nor quantified in advance. And, importantly, even after the outcome is known, “it can be hard to be sure who made a good decision but was penalized by a freak occurrence, and who benefited from taking a flier.” He added that what we can know after the fact was who made the most profitable decision.
All things considered, though, there really is no plausible alternative to the idea that good decisions will lead to long-term profits, while in the short run, “we must be stoic when they don’t.”
He thus divided investors into two schools: the “I know” school and the “I don’t know” school. Those in the “I know” school think they can know the future and put together portfolios intended to make the most profit under just one scenario. They ignore the possibilities of alternative futures.
On the other hand, investors in the “I don’t know” school will recognize potential randomness and construct portfolios that should do well in the most likely scenarios and “not too poorly in the rest.” Members of this group recognize they may experience mediocre results initially, but if they are superior investors, it will show in the long run. Marks doesn’t mention it here, but the cautious investors in the “I don’t know” school should experience fewer losses, especially catastrophic losses.
In addition, Marks argued investors in the “I know” school will name winners and losers after just a few rounds of results, while those in the “I don’t know” school will want to see many rounds before coming to conclusions.
So how do we invest as members of the “I don’t know” school? He had these recommendations, most of which will be familiar to value investors:
- Focus on finding value in the knowable, the fundamentals of companies, industries and securities, rather than on the less-knowable universe of macroeconomics and the broad market shifts.
- Get value on our side through a robust understanding of the fundamentals and buy at a discount.
- Be defensive because outcomes may go against us: “It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.”
- Be contrary when the market is at extremes, as in being greedy when the market is low and fearful when the market is high.
- Since outcomes are uncertain, be skeptical of strategies until they have been tested in a large number of trials.
Summing up, Marks wrote:
“Several things go together for those who view the world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly; insistence on defensive investing; and emphasis on avoiding pitfalls.”
(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.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
