One of the few investors Warren Buffett respects a lot is Howard Marks. Marks is the CEO of Oaktree Capital and is one of the most famous investors who manages to keep a low profile, despite managing almost US$ 90 billion.
Marks is also the author of an amazing book – The Most Important Thing: Uncommon Sense for the Thoughtful Investor. In its ultimate praise, Warren Buffett writes, “This is that rarity, a useful book”.
Apart from the investing gems he has shared through this book, Marks also writes regular memos for investors where he outlines his investment philosophy, in line with what Buffett does via his annual letters to shareholders.
Here is what Buffett has to say about Marks’s memos – “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something…”
From whatever I have read in his memos, Marks focuses a lot on risk control and seeks to exploit market cycles. He prefers judgment to mechanical quantification, and believes in the power of checklists.
His latest memo is a masterpiece in itself. One particular reason it touches a chord with me is because it talks about a pain-point that I feel as an investor each day, and maybe you do too.
Marks writes it under the headline – The Source of Investment Risk.
Howard Marks on investment risk
The first thing he writes here is…
Much (perhaps most) of the risk in investing comes not from the companies, institutions, or securities involved. It comes from the behaviour of investors.
“Yes, I know that!” is the first thought that came to my mind when I read that statement.
“But I’m trying to behave better!” I comforted myself.
It’s then that I read another of Marks statements…
Over the years, I’ve become convinced that fluctuations in investor attitudes toward risk contribute more to major market movements than anything else. I don’t expect this to ever change.
“Hmm, that’s interesting!” I said to myself. “But where does our attitude towards risk hurt us the most?”
Marks has answer to this as well. He writes…
All other things being equal, the price of an asset is the principal determinant of its riskiness.
The bottom line on this is simple. No asset is so good that it can’t be bid up to the point where it’s overpriced and thus dangerous. And few assets are so bad that they can’t become underpriced and thus safe (not to mention potentially lucrative).
Since participants set security prices, it’s their behaviour that creates most of the risk in investing.
Marks gives a couple of non-investing examples to bring home this point about human attitudes…
- Better safety gears can entice climbers to take more risk – making them in fact less safe.
- When traffic controls are removed, traffic flow may double and fatal accidents may fall to zero, presumably because people will drive more carefully.
Just look around yourself and you will find several such examples of twisted human behaviour after people become educated or equipped to avoid such behaviour.
Like drivers in bigger cars drive rashly just because they “feel” safe inside.
Not just our attitude, but more importantly our attitude towards our attitude is the biggest risk we face as investors.
As Marks writes…
The riskiest thing in the investment world is the belief that there’s no risk.
So, is there a solution to the question – “How do I reduce the risk called “I” while investing?”
Well, Marks has an answer for this as well…
…a high level of risk consciousness tends to mitigate risk. I call this perversity of risk.
It’s the reason for Warren Buffett’s dictum that “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
When other people love investments, we should be cautious. But when others hate them, we should turn aggressive.
Marks outlines in an amazing manner a cycle in our attitude in risk-taking, which I produce verbatim below.
If only we can carefully identify where in the cycle we lie at any given point in time, investment decision making would become much easier.
- When economic growth is slow or negative and markets are weak, most people worry about losing money and disregard the risk of missing opportunities. Only a few stout-hearted contrarians are capable of imagining that improvement is possible.
- Then the economy shows some signs of life, and corporate earnings begin to move up rather than down.
- Sooner or later economic growth takes hold visibly and earnings show surprising gains.
- This excess of reality over expectations causes security prices to start moving up.
- Because of those gains – along with the improving economic and corporate news – the average investor realizes that improvement is actually underway. Confidence rises. Investors feel richer and smarter, forget their prior bad experience, and extrapolate the recent progress.
- Skepticism and caution abate; optimism and aggressiveness take their place.
- Anyone who’s been sitting out the dance experiences the pain of watching from the sidelines as assets appreciate. The bystanders feel regret and are gradually sucked in.
- The longer this process goes on, the more enthusiasm for investments rises and resistance subsides. People worry less about losing money and more about missing opportunities.
- Risk aversion evaporates and investors behave more aggressively. People begin to have difficulty imagining how losses could ever occur.
- Financial institutions, subject to same influences, become willing to provide increased financing. In the words of Citibank’s Chuck prince, when the music’s playing, they see no choice but to dance. Thus they compete for market share by reducing the return they demand and by willing to finance riskier deals.
- Easier financing – along with the recent gains – encourages investors to make greater use of leverage. Borrowed capital increase their buying power, and they move to put it to work.
- Leveraged investors report the greatest gains, consistent with the old Las Vegas maxim: “the more you bet, the more you win when you win.” This causes others to emulate them.
- The market takes on the appearance of a perpetual-motion machine. Appreciation accelerates, possibly leading to a mania or bubble. Everyone concludes that things can only get better forever. They forget about the risk of losing money and fixate on not missing opportunities. Leveraged buyers become convinced that the things they buy with borrowed money are certain to appreciate at a rate above their borrowing cost.
- Eventually things get as good as they can get, the last skeptic capitulates, and the last potential buyer buys.
That’s the way the cycle of attitudes towards risk ascends. The skeptic in times of moderation becomes a true believer at the top.
Then the down cycle begins…
- Once the last potential buyer has bought, there’s nobody left to take prices higher.
- A few unemotional, disciplined and foresighted investors conclude that things have gone too far and a correction is in the cards.
- Economic activity and corporate earnings turn down, or they begin to fall short of people’s irrationally expanded expectations.
- The error of those expectations becomes obvious, causing security prices to start declining. Perhaps someone is daring enough to point out publicly that the emperor of limitless growth has no clothes. Sometimes there’s a catalyzing event. Or sometimes (see early 2000) security prices begin to fall of their own accord, simply because they had moved too high.
- The first price declines cause investors to rethink their analysis, conclusions, commitment to the market and risk tolerance. It becomes clear that appreciation will not go on ad infinitum. “I’d buy at any price” is replaced by “how can I know what the right price is?”
- Weak economic news takes the place of positive reports.
- The average investor realizes that things are getting worse.
- Interest in investing declines. Selling replaces buying.
- Investors who sat out the dance – or who just underweighted the depreciating assets – are lionized for their wisdom, and holders start to feel stupid.
- Giddy enthusiasm is replaced by sober skepticism. Risk tolerance declines and risk aversion is on the upswing. People switch from worrying about missing opportunity to worrying about losing money.
- Financial institutions become less willing to extend credit to investors. At the extremes, investors receive margin calls.
- Investors who borrowed to buy are heavily penalized, and the media report on leveraged entities’ spectacular meltdowns. Forced selling in response to margin calls and covenant violations causes price declines to accelerate.
- Eventually we hear some familiar refrains: “I wouldn’t buy at any price,” “There’s no negative case that can’t be exceeded on the downside,” and “I don’t care if I ever make another penny in the market; I just don’t want to lose any more.”
- The last believer loses faith in the market, selling accelerates, and prices reach their nadir. Everyone concludes that things can only get worse forever.
Amazing description of our risk-taking attitude’s cycle, isn’t it?
Well, as Marks writes, we humans will never change and our attitude towards risk-taking will move in a similar cycle always.
But he also outlines a way you can cope with this risk cycle – this is by being contrarian.
In his latest memo, Marks has outlined some simple rules of being contrarian, which I suggest you must read in his memo itself.
Click to read Howard Marks’ latest memo. Then let me know what you learnt from it.
Click to read excerpts of Marks’ memos prepared by a tribesman, Anil K. Tulsiram. Thanks Anil!