Howard Marks' Book: Chapter 14


Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 14 “The Most Important Thing Is…Knowing What You Don't Know” Mistakes, Sizing, Diversification, Leverage, Opportunity Cost

“…the biggest problems tend to arise when investors forget about the difference between probability and outcome – that is, when they forget about the limits on foreknowledge:

  • when they believe the shape of the probability distribution is knowable with certainty (and that they know it),
  • when they assume the most likely outcome is the one that will happen,
  • when they assume the expected result accurately represents the actual result, or
  • perhaps most important, when they ignore the possibility of improbable outcomes.”

“Investors who feel they know what the future holds will act assertively: making directional bets, concentrating positions, levering holdings, and counting on future growth – in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.”

“If you know the future, it’s silly to play defense. You should behave aggressively and target the greatest winners; there can be no loss to fear. Diversification is unnecessary, and maximum leverage can be employed. In fact, being unduly modest about what you know can result in opportunity costs (foregone profits). On the other hand…Mark Twain put it best: ‘It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.’”

A few months ago, we wrote about Michael Mauboussin’s discussion on utilizing the Kelly Formula for portfolio sizing decisions. The Kelly Formula is based upon an investor’s estimation of the probability and amount of payoff. However, if the estimation of probability and payoff amount is incorrect, the mistake will impact portfolio performance through position sizing. It’s a symmetrical relationship: if you are right, the larger position size will help performance; if you are wrong, the larger position size will hurt performance.

Marks’ words echo a similar message. They remind us that an investor’s perception of future risk/reward drives sizing, leverage, and a variety of other portfolio construction and management decisions. If that perception of future risk/reward is correct/incorrect, it will lead to a positive/negative impact on performance, because “tactical decisions like concentration, diversification, and leverage are symmetrical two-way swords.” In order to add value, or generate alpha, an investor must create asymmetry which comes from “superior personal skill.” One interpretation of superior personal skill is correct perception of future risk/reward (and structuring the portfolio accordingly).


“Awareness of the limited extent of our foreknowledge is an essential component of my approach to investing.”

“Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.”

“No one likes having to invest for the future under the assumption that the future is largely unknowable. On the other hand, if it is, we’d better face up to it and find other ways to cope…Whatever limitations are imposed on us in the investment world, it’s a heck of a lot better to acknowledge them and accommodate them than to deny them and forge ahead.”

Investors must embrace uncertainty and the possibility of unpredictable events. Acknowledgement of “the boundaries of what you can know” won’t make you immune from the possible dangers lurking in the unknown future, but at least you won’t be shocked psychologically if/when they occur.

Macro, Luck, Process Over Outcome

“…the future is unknowable. You can’t prove a negative, and that certainly includes this one. However, I have yet to meet anyone who consistently knows what lies ahead macro-wise. Of all the economists and strategists you follow, are any correct most of the time?”

“…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.”

“One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value…It’s possible to be right about the macro-future once in a while, but not on a regular basis. It doesn’t do any good to possess a survey of sixty-four forecasts that includes a few that are accurate; you have to know which ones they are. And if the accurate forecasts each six months are made by different economists, it’s hard to believe there’s much value in the collective forecasts.”

“Those who got 2007-2008 right probably did so at least in part because of a tendency toward negative views. As such, they probably stayed negative for 2009.”