For Howard Marks (Trades, Portfolio), avoiding losses matters much more than aiming for big wins. In chapter 18 of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor,” he gathered and discussed key loss-avoidance issues.
He began by differentiating the main sources of errors into two streams:
- Analytical and intellectual.
- Psychological and emotional.
On the analytical side, there are simple errors such as gathering too much or too little information, using incorrect analytical process or even making simple calculation errors. But there are two lesser-known problems Marks addressed in some detail: Failure of the imagination and not understanding correlation.
When referring to failure of the imagination, he means an inability to recognize the full range of potential outcomes or inability to understand what might happen if there are extreme outcomes. They occur when what “should happen” does not happen.
As we know, the future is under no obligation to behave like the past, and it can take some surprising turns. For an example, he turned to the financial crisis of 2007-08; in his words, “The financial crisis occurred largely because never-before-seen events collided with risky, levered structures that weren’t engineered to withstand them.”
Another failure of the imagination is not understanding how assets correlate with each other in a portfolio or in the broader market. Let’s turn again to the financial crisis, in which Marks argued investors did not anticipate the extreme nature of future events and did not understand the “knock-on consequences” of these extreme events. Financial contagion spread quickly, from American mortgage lenders to the Wall Street giants and to just about every stock listed in markets around the world.
On the psychological and emotional side, he pointed out three ways in which investors are harmed by extreme views and mistakes that lead to bubbles and crashes:
- By giving in to them.
- By unknowingly taking part in markets in which others have succumbed.
- By not taking advantage of distortions when they occur.
Marks went on to analyze those three mistakes in the context of what he calls “one of the most insidious psychological forces: greed.” In the first case, when you give in to greed, you buy overvalued assets because you believe someone will buy them later at a higher price. This is the “greater fool” theory.
The second case, unknowingly participating in an overheated market, is called a failure to notice. It is a ubiquitous problem since it happens to even index funds and passive investors. The third form of error is a failure to take advantage of a distorted market; in this case, it would involve not shorting an overvalued stock (presumably, this is theoretical only for Marks, since shorting is usually a highly speculative—and risky—strategy).
Another type of error is in believing “it’s different this time.” This may be based on a lack of skepticism or from believing some profound limitation no longer exists. As Marks noted:
“There’s always a rational—perhaps even a sophisticated—explanation of why some eighth wonder of the world will work in the investor’s favor. However, the explainer usually forgets to mention that (a) the new phenomenon would represent a departure from history, (b) it requires things to go right, (c) many other things could happen instead and (d) many of those might be disastrous.”
How are we to avoid these errors? The author wrote that markets are a classroom where lessons are taught every day. In other words, we can learn from history. Marks set out to create a list of lessons that might be learned from the 2008 financial crisis, but discovered they were enduring lessons that applied to all extreme bull markets. These are his 11 lessons:
- When too much capital is available, much of it goes to the wrong places. If corporate and investor cash is chasing too few good ideas, some of it will go to bad ideas.
- Bad things happen when capital goes to the wrong places. For example, lenders advance too much to poor risks and, inevitably, there are bankruptcies and losses of various kinds.
- With a surplus of capital available, investors accept low returns and have little margin for error. Think of auctions in which price matters far more than risk and return.
- When no regard for risk is widespread, greater risk is created. This is demonstrated in attitudes such as “I have to buy it right now, because if I don’t someone else will get it.”
- Lack of due diligence turns into investment losses. When good fundamental analysis is skipped because investors are in a hurry, the results will not be satisfactory.
- In frothy bull markets, capital will go into innovative investments that may not stand the test of time. As Marks put it, “Bullish investors focus on what might work, not what might go wrong. Eagerness takes over from prudence, causing people to accept new investment products they don’t understand.”
- Unseen correlations in portfolios can pull down seemingly unrelated assets. Correlations, he said, are often underestimated and grow during crises. This can happen in portfolios that appear to be well diversified, because of extreme events within or beyond the market.
- Fundamentals may be ignored because of psychological and technical factors. While the fundamentals may rule in the long run, it may seem irrelevant in the short term.
- The nature of markets change, making existing models invalid. This has happened to “quant” funds that were based on computer models; when patterns changed, they changed from winners to losers.
- Leverage does not add value. Borrowing may make sense for underpriced assets, but are dangerous when used to buy assets with low returns or narrow risk spreads.
- Excesses, high or low, tend to correct themselves.
Marks added that most of the lessons on this list can be summed up in one: Be alert to what’s happening, including the supply-demand balance for “investable” funds. He noted avoiding pitfalls is not as simple as making rules or using algorithms. Instead, he suggested, “What I would urge is awareness, flexibility, adaptability and a mind-set that is focused on taking cues from the environment.”
(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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