This is the most scientific book on investing I’ve read so far. No wonder Warren Buffett is an avid reader of Howard Marks’s writeups.
Asking ChatGPT what the “gist” of Howard Marks:
The book “The Most Important Thing Illuminated” is a guide to investing and financial markets, written by Howard Marks, the co-founder and co-chairman of Oaktree Capital Management. The book is based on a series of memos that Marks wrote to his clients over the years, in which he shares his insights and thoughts on the markets and on investing. The book covers a wide range of topics, including risk management, value investing, and the psychology of investing.
The central theme of the book is the importance of understanding and managing risk in investing. Marks argues that investors often make mistakes by focusing too much on return and not enough on risk, and that successful investing requires a balanced and thoughtful approach to risk management. He also emphasizes the importance of having a clear investment philosophy and sticking to it, and of staying disciplined and avoiding emotional decision-making. Overall, “The Most Important Thing Illuminated” offers valuable insights and advice for investors of all levels of experience.
ChatGPT
Introduction
Successful investing requires thoughtful attention to many separate aspects, all at the same time.
One cannot develop an effective philosophy without having been exposed to life’s lessons.
Importantly, a philosophy like mine comes from going through life with your eyes open. You must be aware of what’s taking place in the world and of what results those events lead to. Only in this way can you put the lessons to work when similar circumstances materialize again. Failing to do this—more than anything else—is what dooms most investors to being victimized repeatedly by cycles of boom and bust.
“Experience is what you got when you didn’t get what you wanted.”
1. Second-Level Thinking
Remember, your goal in investing isn’t to earn average returns; you want to do better than average. Thus, your thinking has to be better than that of others— both more powerful and at a higher level.
You can’t do the same things others do and expect to outperform.
For your performance to diverge from the norm, your expectations— and thus your portfolio— have to diverge from the norm, and you have to be more right than the consensus. Different and better: that’s a pretty good description of second-level thinking.
2. Understanding Market Efficiency (and Its Limitations)
A corollary that follows from Marks’s observation is that investors should look for markets or assets that are not fully efficiently priced rather than chase after the false god of completely inefficient markets.
Inefficiency is a necessary condition for superior investing.
Investments that are out of favor, that don’t look so attractive in the near term, are avoided by most professionals, who feel they need to add performance right now.
The key turning point in my investment management career came when I concluded that because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.
3. Value
But don’t expect immediate success. In fact, you’ll often find that you’ve bought in the midst of a decline that continues. Pretty soon you’ll be looking at losses. And as one of the greatest investment adages reminds us, “Being too far ahead of your time is indistinguishable from being wrong.” So now that security worth 80 is priced at 50 instead of 60.
Judgments that prove correct don’t necessarily do so promptly, so even the best investors look wrong a lot of the time. If you’re not okay with that, try another field.
It works that way in most places, but far from always, it seems, in the world of investing. There, many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated, and they like it less as the price falls, when they begin to doubt their decision to buy.
If you liked it at 60, you should like it more at 50 … and much more at 40 and 30.
But it’s not that easy. No one’s comfortable with losses, and eventually any human will wonder, “Maybe it’s not me who’s right. Maybe it’s the market.”The danger is maximized when they start to think, “It’s down so much, I’d better get out before it goes to zero.”That’s the kind of thinking that makes bottoms …and causes people to sell there.
4. The Relationship Between Price and Value
Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge.
When you pay for perfection, you don’t get what you expected, and the high price you pay exposes you to risk of loss when reality comes to light. This is truly one of the riskiest things. The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up.
Unlike having an underpriced asset move to its fair value, expecting appreciation on the part of a fairly priced or overpriced asset requires irrationality on the part of buyers that absolutely cannot be considered dependable. • Buying something for less than its value. In my opinion, this is what it’s all about— the most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market’s functioning properly , value exerts a magnetic pull on price.
5. Understanding Risk
Dull, ignored, possibly tarnished and beaten-down securities— often bargains exactly because they haven’t been performing well— are often the ones value investors favor for high returns. Their returns in bull markets are rarely at the top of the heap, but their performance is generally excellent on average , more consistent than that of “hot” stocks and characterized by low variability, low fundamental risk and smaller losses when markets do badly.
6. Recognizing Risk
Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.
The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real.
Risk-averse investors are conscious of the potential for loss and demand compensation for bearing it— in the form of reasonable prices. When investors aren’t sufficiently risk averse, they’ll pay prices that are too high.
A few times in my career, I’ve seen the rise of a belief that risk has been banished, cycles won’t occur any longer, or the laws of economics have been suspended. The experienced, risk-conscious investor takes this as a sign of great danger.
Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as their psychology strengthens and they become bolder and less worried, investors cease to demand adequate risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.
Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.
when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.
7. Controlling Risk
How do you enjoy the full gain in up markets while simultaneously being positioned to achieve superior performance in down markets? By capturing the up-market gain while bearing below-market risk … no mean feat.
But if in the future we always said, “We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,” we’d be frozen in inaction. So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events.
Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.
Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners . Skillful risk control is the mark of the superior investor.
8. Being Attentive to Cycles
“Everything that was good for the market yesterday is no good for it today.”
9. Awareness of the Pendulum
In my opinion, the greed/ fear cycle is caused by changing attitudes toward risk. When greed is prevalent, it means investors feel a high level of comfort with risk and the idea of bearing it in the interest of profit. Conversely, widespread fear indicates a high level of aversion to risk.
When investors in general are too risk -tolerant, security prices can embody more risk than they do return. When investors are too risk-averse, prices can offer more return than risk.
Most important, in the late stages of the great bull markets, people become willing to pay prices for stocks that assume the good times will go on ad infinitum.
10. Combating Negative Influences
The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.
When those forces push markets to extremes of bubble or crash, they create opportunities for superior investors to augment their results by refusing to hold at the highs and by insisting on buying at the lows.
The fourth psychological contributor to investor error is the tendency to conform to the view of the herd rather than resist— even when the herd’s view is clearly cockeyed.
“many people who don’t share the consensus view of the market start to feel left out. Eventually it reaches a stage where it appears the really crazy people are those not in the market.”
In my view, the road to investment success is usually marked by humility, not ego.
But then psychology and crowd influences move in. Much of the time, assets are overpriced and appreciating further, or underpriced and still cheapening. Eventually these trends have a corrosive effect on investors’ psyches, conviction and resolve. The stocks you rejected are making money for others, the ones you chose to buy are lower every day, and concepts you dismissed as unsafe or unwise— hot new issues, high-priced tech stocks without earnings, highly levered mortgage derivatives —are described daily as delivering for others.
To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored.
Emotion and ego: Refusing to join in the errors of the herd— like so much else in investing— requires control over psyche and ego. It’s the hardest thing, but the payoff can be enormous.
11. Contrarianism
To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.
“Buy low; sell high” is the time-honored dictum, but investors who are swept up in market cycles too often do just the opposite. The proper response lies in contrarian behavior: buy when they hate ’em, and sell when they love ’em.
This is where it is particularly important to remember the teachings of Graham and Dodd. If you look to the markets for a report card, owning a stock that declines every day will make you feel like a failure. But if you remember that you own a fractional interest in a business and that every day you are able to buy in at a greater discount to underlying value, you might just be able to maintain a cheerful disposition. This is exactly how Warren Buffett describes bargain hunting amid the ravages of the 1973 to 1974 bear market.
During the crisis, lots of bad things seemed possible, but that didn’t mean they were going to happen. In times of crisis, people fail to make that distinction.
Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t. The best investors I know exemplify this trait. It’s an absolute necessity.
Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.
The herd applies optimism at the top and pessimism at the bottom. Thus, to benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom.
Certain common threads run through the best investments I’ve witnessed. They’re usually contrarian, challenging and uncomfortable— although the experienced contrarian takes comfort from his or her position outside the herd.
The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain.
That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling —and if our view turns out to be right— that’s the route to the greatest rewards earned with the least risk.
12. Finding Bargains
The best opportunities are usually found among things most others won’t do. The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.
The first step is usually to make sure that the things being considered satisfy some absolute standards. Even sophisticated investors may not say, “I’ll buy anything if it’s cheap enough.” More often they create a list of investment candidates meeting their minimum criteria, and from those they choose the best bargains. That’s what this chapter is all about.
13. Patient Opportunism
This is one of the hardest things to master for professional investors: coming in each day for work and doing nothing.
The key is managing clients effectively— which almost always means lowering client expectations.
Standing at the plate with the bat on your shoulders is Buffett’s version of patient opportunism. The bat should come off our shoulders when there are opportunities for profit with controlled risk, but only then. One way to be selective in this regard is by making every effort to ascertain whether we’re in a low -return environment or a high-return environment.
You simply cannot create investment opportunities when they’re not there. The dumbest thing you can do is to insist on perpetuating high returns— and give back your profits in the process. If it’s not there, hoping won’t make it so.
“The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”
You want to take risk when others are fleeing from it, not when they’re competing with you to do so.that by making increasingly risky investments you will incur losses and fall far short, exacerbating your problem.
The absolute best buying opportunities come when asset holders are forced to sell, and in those crises they were present in large numbers.
As I’ve said many times, the real goal of active investment management is to buy things for less than they’re worth. This is what the efficient market hypothesis says we can’t do.
The key during a crisis is to be (a) insulated from the forces that require selling and (b) positioned to be a buyer instead.
To satisfy those criteria, an investor needs the following things: staunch reliance on value, little or no use of leverage, long-term capital and a strong stomach. Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.
14. Knowing What You Don’t Know
We have two classes of forecasters: Those who don’t know— and those who don’t know they don’t know.
There are two kinds of people who lose money: those who know nothing and those who know everything.
Fifth, if the forecasters were sometimes right— and right so dramatically— then why do I remain so negative on forecasts? Because the important thing in forecasting isn’t getting it right once. The important thing is getting it right consistently.
That’s the trouble with inconsistent forecasters: not that they’re never right, but that the record isn’t positive enough to inspire action on their occasional brainstorms.
15. Having a Sense for Where We Stand
We may never know where we’re going, but we’d better have a good idea where we are. That is, even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.
It would be wonderful to be able to successfully predict the swings of the pendulum and always move in the appropriate direction, but this is certainly an unrealistic expectation. I consider it far more reasonable to try to (a) stay alert for occasions when a market has reached an extreme, (b) adjust our behavior in response and, (c) most important, refuse to fall into line with the herd behavior that renders so many investors dead wrong at tops and bottoms.
First, we must be alert to what’s going on. The philosopher Santayana said, “Those who cannot remember the past are condemned to repeat it.” In very much the same way, I believe those who are unaware of what’s going on around them are destined to be buffeted by it.
Everyone sees what happens each day, as reported in the media. But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what we should do in response? Simply put, we must strive to understand the implications of what’s going on around us.
The seven scariest words in the world for the thoughtful investor— too much money chasing too few deals—provided an unusually apt description of market conditions.
However, there are products that can’t be differentiated, and economists call them “commodities.” They’re goods where no seller’s offering is much different from any other. They tend to trade on price alone, and each buyer is likely to take the offering at the lowest delivered price. Thus, if you deal in a commodity and want to sell more of it, there’s generally one way to do so: cut your price. …
One way to lower the price for your money is by reducing the interest rate you charge on loans. A slightly more subtle way is to agree to a higher price for the thing you’re buying, such as by paying a higher price/ earnings ratio for a common stock or a higher total transaction price when you’re buying a company. Any way you slice it, you’re settling for a lower prospective return.
17. Investing Defensively
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.
In contrast, investment results are only partly within the investors’ control, and investors can make good money— and outlast their opponents— without trying tough shots. The bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match.
Oaktree portfolios are set up to outperform in bad times, and that’s when we think outperformance is essential. Clearly, if we can keep up in good times and outperform in bad times, we’ll have above-average results over full cycles with below-average volatility, and our clients will enjoy outperformance when others are suffering.
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.
Here is part of the tradeoff with diversification. You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term.
The prudent lender’s reward comes only in bad times, in the form of reduced credit losses. The lender who insists on margin for error won’t enjoy the highest highs but will also avoid the lowest lows.
• They bet too much when they think they have a winning idea or a correct view of the future, concentrating their portfolios rather
than diversifying. • They incur excessive transaction costs by changing their holdings too often or attempting to time the market.
Playing offense, bearing risk and operating in technically challenging fields mustn’t be attempted without the requisite competence.
if you’re dominated by an unwillingness to be wrong, you’ll never be able to adopt the lonely, contrarian positions required for serious investment success.
18. Avoiding Pitfalls
An investor needs do very few things right as long as he avoids big mistakes. WARREN BUFFETT
Relying to excess on the fact that something “should happen” can kill you when it doesn’t. Even if you properly understand the underlying probability distribution, you can’t count on things happening as they’re supposed to. And the success of your investment actions shouldn’t be highly dependent on normal outcomes prevailing; instead, you must allow for outliers.
As an aside, it’s worth noting that the assumption that something can’t happen has the potential to make it happen, since people who believe it can’t happen will engage in risky behavior and thus alter the environment.
You could require your portfolio to do well in a rerun of 2008, but then you’d hold only Treasurys, cash and gold. Is that a viable strategy?
Probably not. So the general rule is that it’s important to avoid pitfalls, but there must be a limit. And the limit is different for each investor.
Understanding and anticipating the power of correlation —and thus the limitations of diversification—is a principal aspect of risk control and portfolio management, but it’s very hard to accomplish. The failure to correctly anticipate co-movement within a portfolio is a critical source of investment error.
Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them.
Leverage magnifies outcomes but doesn’t add value. It can make great sense to use leverage to increase your investment in assets at bargain prices offering high promised returns or generous risk premiums. But it can be dangerous to use leverage to buy more of assets that offer low returns or narrow risk spreads— in other words, assets that are fully priced or overpriced. It makes little sense to use leverage to try to turn inadequate returns into adequate returns.
When there’s nothing particularly clever to do, the potential pitfall lies in insisting on being clever.
19. Adding Value
I’m going to introduce two terms from investment theory. One is beta, a measure of a portfolio’s relative sensitivity to market movements. The other is alpha, which I define as personal investment skill, or the ability to generate performance that is unrelated to movement of the market.
Active investors who don’t possess the superior insight described in chapter 1 are no better than passive investors, and their portfolios shouldn’t be expected to perform better than a passive portfolio. They can try hard, put their emphasis on offense or defense, or trade-up a storm, but their risk-adjusted performance shouldn’t be expected to be better than the passive portfolio.
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 expected to be more volatile than the reference market, and a beta below 1 means it’ll be less volatile. Multiply the market return by the beta and you’ll get the return that a given portfolio should be expected to achieve,
It means relatively little that a risk taker achieves a high return in a rising market, or that a conservative investor is able to minimize losses in a decline. The real question is how they do in the long run and in climates for which their style is ill-suited.
The key to this matrix is the symmetry or asymmetry of the performance.
On the other hand, the performance of investors who add value is asymmetrical. The percentage of the market’s gain they capture is higher than the percentage of loss they suffer.
Everything in investing is a two-edged sword and operates symmetrically, with the exception of superior skill.
If we’re consistently able to decline less when the market declines and also participate fully when the market rises, this can be attributable to only one thing: alpha, or skill. That’s an example of value-added investing , and if demonstrated over a period of decades, it has to come from investment skill.
20. Reasonable Expectations
Rather, our disinterest in market timing means— above all else— that if we find something attractive, we never say, “It’s cheap today, but we think it’ll be cheaper in six months , so we’ll wait.”
21. Pulling It All Together
Only a strong sense of value will give you the discipline needed to take profits on a highly appreciated asset that everyone thinks will rise nonstop, or the guts to hold and average down in a crisis even as prices go lower every day.
The superior investor never forgets that the goal is to find good buys, not good assets.
“What the wise man does in the beginning, the fool does in the end.”
It’s impossible to know when an overheated market will turn down, or when a downturn will cease and appreciation will take its place. But while we never know where we’re going, we ought to know where we are. We can infer where markets stand in their cycle from the behavior of those around us. When other investors are unworried, we should be cautious; when investors are panicked, we should turn aggressive.
Buying based on strong value, low price relative to value, and depressed general psychology is likely to provide the best results. Even then, however, things can go against us for a long time before turning as we think they should. Underpriced is far from synonymous with going up soon. Thus the importance of my second key adage: “Being too far ahead of your time is indistinguishable from being wrong.”It can require patience and fortitude to hold positions long enough to be proved right.
The risk that matters most is the risk of permanent loss.