“In theory, there is no difference between theory and practice. In practice, there is.” — Yogi Berra, as quoted by Howard Marks.
Over the past ten to fifteen years, behavioral finance has gained more attention within academia as a discipline worth careful study. Nearly fifty years after the efficient market hypothesis and modern portfolio theory gained widespread traction among investment practitioners, academics and practitioners alike have increasingly come to the conclusion that central tenets of market efficiency are either inconsistent or entirely absent in the real world. In other words, the world is finally listening to the message that Howard Marks has been communicating for decades.
Howard Marks is Chairman of Oaktree Capital Management and has made his memos to clients available to the public for many years. Oaktree, with $80 billion under management, specializes in less efficient markets with a focus on distressed debt investing and alternative investments. Mr. Marks made a keynote address today at the Columbia Investment Management Association’s investment conference.
The Most Important Thing
Mr. Marks focused his presentation on the general themes that are covered in his forthcoming book, The Most Important Thing, scheduled for release on May 24, 2011. As a broad theme, “the most important thing” refers to the need for investors to go beyond the simplistic and mechanistic approaches that essentially present the recipe for successful investing as one would read a recipe from a cookbook. Mr. Marks refers to his approach as “second-level thinking”.
Second-level thinking boils down to the ability to ascertain the set of probable outcomes that can occur and to think in probabilistic terms when it comes to weighing the consequences of different scenarios. In contrast, most investors tend to develop working theories about how the future will unfold and then invest as if that outcome will occur, ignoring the broad range of possible outcomes and particularly the “fat tail” outcomes that have been appearing with more frequency than expected in recent years, to say the least. Mr. Marks refers to this flawed approach as “single scenario investing”.
Textbook Economics Fails in Financial Markets
Mr. Marks went through a number of scenarios in which human beings involved in financial markets clearly do not operate within the norms of economics. For example, in normal markets, individuals have higher demand for products as they become cheaper. This is why the classic demand curve is downward sloping: as the price of something decreases (on the y-axis), the quantity demanded increases (along the x-axis).
However, the reverse appears to be true with investments. When prices are high and rising higher, investors tend to want to buy more of the security in question and the opposite is true when prices are falling and investors then seek to sell. The investment demand curve appears to be upward sloping: as prices rise, investors demand more of a security; as prices fall, investors rush to sell what they have.
Mr. Marks refers to the periodic shifts between greed and fear as “the swing of the pendulum”. There is massive fluctuation between optimism and pessimism and the time spent at the happy medium when markets are in equilibrium is quite small compared to time spent rising or falling to extremes of the pendulum.
Fear of Loss vs. Pain of Embarrassment
Why do investors behave in irrational ways? Part of the answer is simply human nature. Investors fear both losses and missed opportunity. As a result, in a bull market, investors tend to join the herd just as valuations are going to extreme levels because they see other investors doing the same thing and making money. Investors who do not have personal memory of the last bubble may believe that bears are simply naysayers who “don’t get it” rather than being worth listening to (the “new era” of the late 1990s is the most obvious recent example.)
Short Term Records Are Misleading
Perhaps the most important point Mr. Marks made during his presentation is the folly that comes from paying too much attention to short term records. After all, people can appear to be right for the wrong reasons. A good decision should not necessarily be measured by whether a positive outcome occurred based on a single decision. In contrast, a good decision is one that, in retrospect, took proper measure of all known scenarios and was taken based on an intelligent view of the probability of multiple outcomes.
Many good decisions can fail to work when applied to a specific situation while plenty of bad decisions can work. Viewed in this light, the methodology an investor follows — the process by which the decision is made — is more important than the outcome in any specific case. It may be easier to predict future performance over a long period of time by analyzing the decision process rather than the outcome of any one decision.
I will attempt to obtain a review copy of the book prior to publication and will publish a more complete review at that time.
Additional disclosure: This is a report on the Columbia Investment Management Association conference that took place in New York on February 4. Seeking Alpha obtained my pass and this is the article I promised to provide in exchange for the pass.