Howard Marks (Trades, Portfolio) began chapter 17 of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor” by citing a question he asks potential investors: “Which do you care about more, making money or avoiding losses?”
The inevitable answer? “Both.” And then he points out that no one can have both, you cannot stretch for above-average profits and be cautious at the same time. Some sort of balance must be reached, and trade-offs must be made.
There is a balance he recommended, which he gets to later in the chapter. But first, he illuminated the choices with an extended sports analogy. Indeed, Marks himself was seriously influenced by an article by Charles Ellis titled, “The Loser’s Game.” Appropriately, it was published in The Financial Analysts Journal in 1975.
Ellis used professional and amateur tennis players as an example. Professional tennis players play a “winning” game because their games usually are won by the players who make the best shots.
Amateur players, on the other hand, mostly focus on a “loser’s game,” meaning they try to keep the ball in play until the other player hits the ball off the court, into the net or misses the ball altogether (Marks concedes this was his tennis strategy as well). In this type of game, points are not won, they are lost, and whoever loses least wins the game. More broadly, this is known as a loss-avoidance game.
Ellis went on to apply these lessons to investing, with Marks writing, “His views on market efficiency and the high cost of trading led him to conclude that the pursuit of winners in the mainstream stock markets is unlikely to pay off for the investor. Instead, you should try to avoid hitting losers. I found this view of investing absolutely compelling.”
Whether one adopts a “winning” or “loss-avoidance” strategy should be a function of how much investors believe they are in control of the investing world. As Marks observed, there is a lot about investing over which we have no control.
There are many variables that can take random paths and, as a result, “investing is full of bad bounces and unanticipated developments, and the dimensions of the court and the height of the net change all the time.” In addition, there is always the random behavior of the market to make the future even more difficult to predict.
So even the best of investors can be rocked unexpectedly, despite doing everything right. Other investors take no notice of your stock, management makes mistakes, governments change the rules and even nature can interfere with catastrophes. At least some defensive play is essential and, from there, the next step for investors is to aim for an appropriate balance.
“They can be aggressive, hoping they’ll make a lot on the winners and not give it back on the losers. They can emphasize defense, hoping to keep up in good times and excel by losing less than others in bad times. Or they can balance offense and defense, largely giving up on tactical timing but aiming to win through superior security selection in both up and down markets.”
Marks and his investment management company, Oaktree Capital, think they have found a good balance. When times are good, they’re satisfied to keep up with indexes. In bad times, they aim to outperform the market. Over the course of a full cycle, they expect to enjoy above-average returns with less-than-average volatility.
That’s his positioning; other investors should set their own balances based on their personalities and inclinations, faith in their own abilities and so on. For those with a more defensive posture, the emphasis will not be on doing the right thing so much as not doing the wrong thing.
But defense is not entirely negative:
“While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or nonaspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.”
Two elements make up an investment defense. The first is to exclude losers from portfolios, with good fundamental research (due diligence), high standards, low prices and a margin of safety.
The second element involves avoiding poor years and exposure to meltdowns during crashes. Tactics supporting this are “thoughtful” diversification, limits on risk exposure and “a general tilt toward safety.” On the flip side, it means a non-concentrated portfolio and no leverage; both lead to higher highs and lower lows.
Getting back to the first element, Marks made a point of emphasizing margin of error, calling it the “critical element.” He noted it is possible to do very well if the future unfolds as you expect, “but you might want to give some thought to how you’ll fare if the future doesn’t oblige. In short, what is it that makes outcomes tolerable even when the future doesn’t live up to your expectations? The answer is margin for error.” He added that low price is the ultimate source of margin of error.
Finally, Marks wrote, “Many see this decision as the choice between aspiring for more and settling for less. For the thoughtful investor, however, the answer is that defense can provide good returns achieved consistently, while offense may consist of dreams that often go unmet. For me, defense is the way to go.”
(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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