The Most Important Thing – by Howard Marks

The Most Important thing’s Howard Marks is the Founder of Oaktree Capital Management, who hold US$122 billion in assets under management. This book is a compilation of all his investment philosophies, which can be applied to help you make better decisions when investing money, time or energy. There isn’t any step-by-step instructions, just advice on ways to thinking to avoid the many pitfalls that most investors fall in. In this episode we cover:

• Second level thinking
• Understanding market efficiency,
• Understanding, recognising and controlling risk,
• Combatting the negative influences of human nature, and
• Knowing what you don’t know

Grab a copy of the book here: https://www.bookdepository.com/Most-Important-Thing-Howard-Marks/9780231153683/?a_aid=adamsbooks

We are planning on having another Q&A episode to cap off another great season. If you would like to leave a question, head to: www.whatyouwilllearn.com/question

The Most Important Thing Summary

There are 18 ‘most important things’ according to Howard Marks. Successful investing requires thoughtful attention to many separate aspects, all at the same time. Omit any and the result is likely to be less than satisfactory. This book is not a ‘how to’ for investing, it’s a book on investment philosophy. It includes no  step-by-step instruction, no valuation formulas – just a way to think, a way to help you make more good decisions and avoid the pitfalls that so many people fall in to.

  1 – The most important thing is… second-level thinking

  Valid approaches work some time but not all. Successful investing can’t be reduced to an algorithm on a computer – no rule works. The environment isn’t controllable and circumstances rarely repeat exactly. Investing like economics, is more art than science, therefore it can’t be routinized. Investments approaches therefore need to be intuitive and adaptive rather than be fixed and mechanistic. That’s the definition of successful .investing – doing better than the market and other investors. To do that, you need either good luck or superior insight. Remember your goal in investing isn’t to earn average returns, you want to do better than average, thus your thinking needs to be better than that of others.

   What is second level thinking? 1st level thinking says  – “it’s a good company, lets buy the stock” 2nd level says –  “it’s a good company. But everyone think it’s a great company, and it’s not. The second level thinker takes into account:

What does the consensus think?

What’s the probability I’m right?

Is the consensus psychology that’s incorporated into the price too bullish or bearish?

  The Most Important thing shows first level thinkers think the same way other first level thinkers do about the same things, and they generally reach the same conclusions. Before competing in the zero sum game of investing, you must have good reason to think you’re in the top half.

  The most important thing is…. understanding market efficiency (and its limitations)

  The efficient market hypothesis states that:

“There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed”. Because of the collective efforts of these participants, information is reflected fully and immediately in the market price of each asset. As  market participants move an instant to buy asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other. Thus market prices represent accurate measurements of assets’ intrinsic values. Riskier assets offer higher returns in order to attract buyers. The free market will set prices so that appears to be the case, there won’t be any free lunch. Now Howard looks at it differently:

It’s efficient, but not right For example, in January 2000, Yahoo sold at $237. In April 2001, it was $11. Anyone who argues that the market was right both times has their head in the clouds. The bottom line is although more efficient markets often misvalue assets, it’s not easy for one person with the same information as everyone else to not be subject to the same psychological influences. Is the market unbeatable, are people who try just wasting their time? Are the clients who pay fees to investment managers wasting their money?

  With millions of people doing the similar analysis on the basis of similar information, how often will stocks become mispriced? And how regularly can one detect those? Answer – not often and not dependably. But that is the essence of second level thinking. The first test is always the same, when receiving information – “and who doesn’t know that?” Second level thinkers depend on inefficiency. Where do the errors come from?

  The most important thing is….. understanding risk

  Investing consists of exactly one thing: dealing with the future and because none of us know the future with certainty, risk is inescapable – thus dealing with it is essential.  When you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks. Markets set themselves up so that risker assets appear to offer higher returns If that weren’t the case, then who’d buy them?

   Riskier investments are those for which the outcome is less certain. The probability distributions are much wider. Higher expected returns, includes possibility of lower returns and in some cases, some losses.

  The most important thing is…. recognizing risk

  Recognizing risk often starts with understanding when investors are paying it too little heed, being too optimistic and paying too much for a given asset as a result. High risk, in other words comes with higher prices. Whether it be an individual security or other asset that is overrated and thus overpriced, or an entire market that’s been borne aloft by bullish sentiment and is thus sky high, participating when prices are high rather than shying away is the main source of risk.

  Along the upward swing of the pendulum, people forget that truth and and embrace risk to the excess. In bull markets, people say “risk is my friend. The greater risk I take, the greater my return will be – I’d like more risk please”. Risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept it without being compensated to do so, and risk compensation will disappear. This is a simple and inevitable relationship. There are fewer things riskier than the widespread belief that there’s no risk.

  Whatever awards are presented for risk, they’re never given out in good times. The reason risk is covert, is because it’s invisible. Risk the possibility of loss is not observable. What is observable Is loss, and loss generally happens when risk collides with negative events. Germs cause illness, but germs themselves are not illness. We might say illness is what results when germs take hold. Homes in California may or may not have construction flaws, that would make them collapse during Earthquakes. We find out only when earthquake occurs. Likewise, loss is what happens when risk meets adversity.

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