At the beginning of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor,” Howard Marks (Trades, Portfolio) wrote about the difference between “first-level thinking” and “second-level thinking.”
Essentially, first-level thinkers are content to do cursory research and follow the recommendations of others. Second-level thinkers ignore the others and do their own analyses of the fundamentals; with that data, they think hard about the companies they are considering. Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) are prominent second-level thinkers; they both ignore the daily chatter and instead spend their days (and perhaps half their nights) reading annual reports, financial statements, industry information and similar materials.
Second-level thinkers are also what Marks called superior or skilled investors. They generally do better than the market average because they add value; this added value is called “alpha.” It is one of two technical terms addressed in chapter 19; the other is “beta,” which refers to the relative sensitivity of a portfolio to market movements and expressed as volatility or stock price fluctuations.
As a starting point, every investor has an opportunity to earn the market average by owning a passive index fund. As Marks noted, “It epitomizes investing without value added.”
Active investors, on the other hand, are not satisfied with earning just the average, they want higher returns. And, the difference between an average and a higher return is alpha. These investors can take one of a couple of avenues in trying to generate alpha.
First, they can be more aggressive or defensive than the index, whether permanently or by market timing (as in responding to cycles or events). Among the tools available are leverage and overweighting stocks in the index with higher beta (fluctuating more than average). In both cases, they add risk (beta) to the portfolio. Thus, returns may be higher, but the risk-adjusted return will be the same.
Another approach is to use one’s stock-picking ability; these investors deviate from the index by underweighting some stocks and overweighting others, or even adding stocks not present in the index. This allows them, in theory at least, to profit from company-specific events or price movements. Using this approach, superior investing skills are essential, otherwise the extra gains will be cancelled out by extra losses.
For example, aggressive investors who take on extra risk should beat the index in good times, but also lag it in bad times. At this point, Marks brought back the concept of beta, providing this definition:
“By the word beta, theory means relative volatility, or the relative responsiveness of the portfolio return to the market return. A portfolio with a beta above 1 is more volatile than the reference market, and a beta below 1 means it’ll be less volatile.”
Based on this definition, you can multiply the market’s average return by the beta to see what a portfolio should be expected to return. For example, if the market gains 15% (based on a measure such as the S&P 500), a portfolio with a 1.2 beta should return 18% (15% x 1.2). The extra return is, of course, based on additional risk.
Marks then offered the formula for portfolio performance:
y = α+βx
Performance is “y,” alpha is “α,” beta is “β” and the market return is “x.” In words, the performance of a portfolio equals alpha (investing skill) plus beta (relative volatility) multiplied by the market return.
Put another way, a manager who earns 18% by taking on greater risk is no better than a manager who earned 15% without adding risk. Marks wrote:
“The alpha/beta model is an excellent way to assess portfolios, portfolio managers, investment strategies and asset allocation schemes. It’s really an organized way to think about how much of the return comes from what the environment provides and how much from the manager’s value added.”
Two important implications can be teased out of this conclusion:
- “Beating the market” does not have the same meaning as “superior investing.”
- “It’s not just your return that matters, but also what risk you took to get it.”
Marks added that you cannot judge yourself, or a manager, on just one year’s worth of earnings because returns must be averaged over both good times and bad times to be relevant.
In this chapter, the author often uses the word “asymmetrical,” as in the sense that superior investors will capture more of the market’s gains than they lose during the market’s losses. In his words.
“Everything in investing is a two-edged sword and operates symmetrically, with the exception of superior skill. Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek.”
With that, he turned to his company, Oaktree Capital, which aspires to match the market in good years and to beat it in bad years. He said that may not seem an ambitious goal, but in reality it is.
In good years, its portfolios must include “good measures of beta and correlation with the market.” Those same measures of beta and correlation should also hurt its portfolios in bad years, but the firm has generally declined less than the market thanks to alpha.
And so the firm can claim asymmetric returns. Marks wrote, “Asymmetry—better performance on the upside than on the downside relative to what your style alone would produce—should be every investor’s goal.”
Finally, not explained in this chapter is the way he uses the concept of risk;Â i.e., that risk is a function of volatility. In earlier chapters, he emphasized that risk refers to the potential loss of capital. There may be something I’m missing here, but I’m not yet sure why he used risk as volatility in this chapter. Your thoughts would be appreciated.
(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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