by Daniel Sparks
Though fundamental analysis does play an integral and necessary role for successful value investing, I've always felt that it's an investor's grasp of behavioral finance that will set him or her apart from the pack.
In his new book, The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor, Howard Marks, Chairman of Oaktree Capital, reaffirms the importance of our attitude toward risk.
This version of the book includes annotation throughout the book by Christopher Davis, Joel Greenblatt, Paul Johnson, and Seth A. Klarman. Plus, Howard Marks chimes in as well with some annotation and an entirely new (and outstanding) chapter: Reasonable Expectations.
The "Human" Side of Investing
The focus of the book is on what Marks calls the "human" side of investing. He defines this as "how to think and how to deal with the psychological influences that interfere with investment thinking" (p. 4). Marks avoids the step-by-step guides and valuation models and focuses on ways in which investors can avoid the pitfalls that can suddenly ruin any intelligent investor's portfolio.
The 4 "key themes" of Marks' annotations characterize the "human" side of investing:
- "The riskiest things" - The many things that often make investing perilous.
- "Emotion and ego" - I can't find a better way to say it than Marks:
..financial analysis won't guarantee superior performance if your reactions to developments are skewed by psychology just like those of others. (p. 44) - Howard Marks
- "Fear of looking wrong" - If the goal of value investing is to buy below intrinsic value, then the value investor is going to need some serious contrarian conviction to hold on to the stock until the market comes to agree with you and prices the stock closer to intrinsic value.
- "Understanding uncertainty" - Value investing deals with forecasting the future. This requires investors to embrace some measure of uncertainty and attempt to minimize it as much as possible.
An investor's awareness and approach toward each of these 4 key themes of "human" investing can make or break him.
A Contrarian Approach is Required
I have great respect for value investors. Essentially, all of us firmly believe that we can look at things differently from the rest of the market. If we felt that our opinion on any opportunity was the consensus, then we wouldn't find any value in that specific opportunity.
But the problem with being a contrarian is that it is not easy (and hence my great respect for value investors). Consider the conditions necessary to succeed as a value investor:
- Accurate (or at least somewhat accurate) valuation
- Our valuation must be non-consensus
- We must act on our non-consensus valuation
As Marks explains, "The problem is that extraordinary performance comes only from correct non-consensus forecasts, but non-consensus forecasts are hard to make, hard to make correctly and hard to act on."
Inefficiencies - mispricings, misperceptions, mistakes that other people make - provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. - Howard Marks
Some Thoughts on Risk
The contributing authors in the annotations often refer to Marks' sayings as "Howardisms" due to their inherent truth and formidable ways of communicating it. I'll leave you with some "Howardisms" on risk and some thoughts from the other authors that contributed to the annotations:
- Marks: "When you boil it all down, it's the investor's job to intelligently bear risk for profit. Doing it well is what separates the best from the rest."
- Johnson: "Controlling risk in your portfolio is a very important worthwhile pursuit. The fruits, however, come only in the form of losses that don't happen. Such what-if calculations are difficult in placid times."
- Marks: "Return has to be evaluated relative to the amount of risk taken to achieve it"
- Marks: "Inadequate skepticism contributes to investment losses"
- Marks: "When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there's chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so."
Ultimately The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor is an outstanding read. I'll be referring back to it often. I'd say it's a must-have for every value investor.