Howard Marks' Book: Chapter 6 - Part 2

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 6 “The Most Important Thing Is…Recognizing Risk” Marks does a fantastic job illustrating the impact of the (low) risk free rate on portfolio expected risk & return, position selectivity, hurdle rate & opportunity cost.

Expected Return, Hurdle Rate, Opportunity Cost, Risk Free Rate, Selectivity

“The investment thought process is a chain in which each investment sets the requirement for the next…The interest rate on the thirty-day T-bill might have been 4 percent. So investors, says, ‘If I’m going to go out five years, I want 5 percent. And to buy the ten-year note I have to get 6 percent.’ Investors demand a higher rate to extend maturity because they’re concerned about the risk to purchasing power, a risk that is assumed to increase with time to maturity. That’s why the yield curve, which in reality is a portion of the capital markets line, normally slopes upward with the increase in asset life.

Now let’s factor in credit risk. ‘If the ten-year Treasury pays 6 percent, I’m not going to buy a ten-year single-A corporate unless I’m promised 7 percent.’ This introduces the concept of credit spread. Our hypothetical investor wants 100 basis points to go from a ‘guvvie’ to a ‘corporate’…

What if we depart from investment-grade bonds? ‘I’m not going to touch a high yield bond unless I get 600 over a Treasury note of comparable maturity.’ So high yield bonds are required to yield 12 percent, for a spread of 6 percent over the [ten-year] Treasury note, if they’re going to attract buyers.

Now let’s leave fixed income altogether. Things get tougher, because you can’t look anywhere to find the prospective return on investments like stocks (that’s because, simply put, their returns are conjectural, not ‘fixed’). But investors have a sense for these things. ‘Historically S&P stocks have returned 10 percent, and I’ll buy them only if I think they’re going to keep doing so…And riskier stocks should return more; I won’t buy on the NASDAQ unless I think I’m going to get 13 percent.’

From there it’s onward and upward. ‘If I can get 10 percent from stocks, I need 15 percent to accept the illiquidity and uncertainty associated with real estate. And 25 percent if I’m going to invest in buyouts…and 30 percent to induce me to go for venture capital, with its low success ratio.’

That’s the way it’s supposed to work…a big problem for investment returns today stems from the starting point for this process: The riskless rate isn’t 4 percent; it’s close to 1 percent…Typical investors still want more return if they’re going to accept time risk, but with the starting point at 1+ percent, now 4 percent is the right rate for the ten-year (not 6 percent)…and so on. Thus, we now have a capital market line…which is (a) at a much lower level and (b) much flatter.”

“…each investment has to compete with others for capital, but this year, due to low interest rates, the bar for each successively riskier investment has been set lower than at any time in my career.” Most investors have, at some point, gone through a similar thought process:

• Should I make this investment?
• What is the minimum return that will compel me to invest? (For discussion purposes, we’ll call this the Hurdle Rate.)
• How do I determine my hurdle rate?

Based on the quotes above, the hurdle rate is determined based upon a mixture of considerations including: (1) the risk-free rate (2) the expected return of other available investments or asset classes, and (3) perhaps a measure of opportunity cost (for which the calculation opens a whole new can of worms).

In essence, this is a selectivity exercise, comparing the expected returns between possible investment candidates along the “risk” spectrum. After all, “each investment has to compete with others for capital” because we can’t invest in everything.

Howard Marks highlights a problematic phenomenon of recent days: the declining risk-free-rate pushing down the starting point for this exercise, and consequently the entire minimum return requirement (hurdle rate) curve for investors.

So the following questions emerge:

• Is your minimum return requirement (hurdle rate) curve relative or absolute vs. the crowd?
• If relative, do you join the crowd and lower your minimum return hurdle rate?
• Just a little, you say? Is there a point at which you draw the proverbial line in the sand and say “no further” because everyone has lost their minds?
• Do you then go to cash? Is there any another alternative? Are you prepared to miss out on potential returns (as other investors continue to decrease their hurdle rates and chase assets/investments driving prices even higher)?

Wait, this sounds very familiar. Remember our Part 1 discussion on “risk manifestation” due to irrational market participant behavior and high asset prices?

Risk, Expected Return

“…the herd is wrong about risk at least as often as it is about return.”

We have often discussed the concept of expected return (a forward looking prediction on future return outcome), but we have been remiss in discussing the concept of expected risk (a forward looking prediction on future risk outcome).

Misguided predictions of either expected return or expected risk have the potential to torpedo investment theses.

Howard Marks' Book: Chapter 6 - Part 1

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 6 “The Most Important Thing Is…Recognizing Risk” Risk, Intrinsic Value, Psychology

“Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.”

“It’s also ephemeral and unmeasurable. All this makes it very hard to recognize, especially when emotions are running high. But recognize it we must.”

“…the theorist thinks return and risk are two separate things, albeit correlated, the value investors thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices. Thus, awareness of the relationship between price and value – whether for a single security or an entire market – is an essential component of dealing successfully with risk….Dealing with this risk starts with recognizing it.”

“High risk, in other words, comes primarily with high prices.”

“…the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions.”

“The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it. Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the ‘perversity of risk.’”

“No matter how good fundamentals may be, humans exercising their greed and propensity to err have the ability to screw things up.” As Marks points out, there exists an unbreakable relationship between the purchase price (relative to the intrinsic value) of an investment, and the level of risk within an investment. In other words, a portion of the risk of any investment is price dependent.

But price is a moving target, nudged around by the actions of market participants. Therefore, there’s also a link between the behavior of market participants and the manifestation of risk.

So the curious bug wonders, is the existence of risk absolute? Or does it only emerge under certain circumstances, such as when market participants drive asset prices sky high? Marks calls the latter the “perversity of risk” – a monster of our own creation.

If risk does manifest only at certain times due to market participant behavior, then in order to recognize risk, we must keep an acute awareness of not only our own actions, but also our surroundings and the actions of other market participants (as it relates to price vs. intrinsic value).

Howard Marks' Book: Chapter 5 - Part 4

I'm finally back from vacation. In light of recent market volatility and "risk," let's kick off with a continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk” Risk, Intrinsic Value

“…risk of loss does not necessarily stem from weak fundamentals. A fundamentally weak asset – a less-than-stellar company’s stock, a speculative-grade bond or a building in the wrong part of town – can make for a very successful investment if bought at a low-enough price.”

“Theory says high return is associated with high risk because the former exists to compensate for the latter. But pragmatic value investors feel just the opposite: they believe high return and low risk can be achieved simultaneously by buying things for less than they’re worth. In the same way, overpaying implies both low return and high risk.”

There exists an unbreakable relationship between the purchase price (relative to the intrinsic value) of an investment, and the inherent risk of that investment. In other words, a portion of the risk of any asset is price dependent.

Risk

Howard Marks highlights a few other types of risk, beyond is usual loss of capital, etc. Investment risk can take on many other forms – personal and subjective – varying from person, mandate, and circumstance.

“Falling short of one’s goal – …a retired executive may need 4 percent…But for a pension fund that has to average 8% per year, a prolonged period returning 6 percent would entail serious risk. Obviously this risk is personal and subjective, as opposed to absolute and objective…Thus this cannot be the risk for which ‘the market’ demands compensation in the form of higher prospective returns.”

“Underperformance – …since no approach will work all the time – the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up. (See Warren Buffett and Julian Robertson in 1999.)”

“Career Risk – …the extreme form of underperformance risk…risk that could jeopardize return to an agent’s firing point…”

“Unconventionality – …the risk of being different. Stewards of other people’s money can be more comfortable turning in average performance, regardless of where it stands in absolute terms, than with the possibility that unconventional actions will prove unsuccessful and get them fired.”

“Illiquidity – …being unable when needed to turn an investment into cash at a reasonable price.”

Theory suggests that asset returns compensate for higher “risk.” If this is true, how then do assets compensate for subjective risks that vary from person to person, such as falling short of one’s return goal, or career risk stemming from unconventionality?

This highlights the necessity for portfolio managers to identify and segment risks – objective or subjective & quantitative or qualitative – before implementing risk management or hedging strategies.

Risk, Fat Tail

“‘There’s a big difference between probability and outcome. Probable things fail to happen – and improbable things happen – all the time.’ That’s one of the most important things you can know about investment risk.”

“The fact that an investment is susceptible to a particularly serious risk that will occur infrequently if at all – what I call the improbable disaster – means it can seem safer than it really is.”

“…people often use the terms bell-shaped and normal interchangeably, and they’re not the same…the normal distribution assumes events in the distant tails will happen extremely infrequently, while the distribution of financial developments – shaped by humans, with tendency to go to emotion-driven extremes of behavior – should probably be seen as having ‘fatter’ tails…Now that investing has become so reliant on higher math, we have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world.” 

Howard Marks' Book: Chapter 5 - Part 3

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk” No commentary necessary - self explanatory and eloquently written.

Definition of Investing, Risk

“Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.”

Risk, Process Over Outcome, Luck

“Many futures are possible…but only one future occurs…Many things could have happened in each case in the past, and fact that only one did happen understates the variability that existed.”

“In the investing world, one can live for years off one great coup or one extreme but eventually accurate forecast. But what’s proved by one success? When markets are booming, the best results often go to those who take the most risk. Were they smart to anticipate good times and bulk up on beta, or just congenitally aggressive types who were bailed out by events? Most simply put, how often in our business are people right for the wrong reasons? These are the people Nassim Nicholas Taleb calls 'lucky idiots,' and in the short run it’s certainly hard to tell them from skilled investors.

The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed. Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa. With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)? And ditto for a loser: how do we ascertain whether it was a reasonable but ill-fated venture, or just a wild stab that deserved to be punished?

Did the investor do a good job of assessing the risk entailed? That’s another good question that’s hard to answer. Need a model? Think of the weatherman. He says there’s a 70 percent chance of rain tomorrow. It rains; was he right or wrong? Or it doesn’t rain; was he right or wrong? It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.”

Howard Marks' Book: Chapter 5 - Part 2

The following excerpt from Howard Marks' book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk,” is one of the best clarifications on the relationship between risk and return that I have ever read. Risk, Expected Return

“…when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return…Clearly, return tells just half of the story, and risk assessment is required.”

“…‘capital markets line’ that slopes upward to the right, indicating the positive relationship between risk and return…the familiar graph…is elegant in its simplicity. Unfortunately, many have drawn from it an erroneous conclusion…if riskier investments reliable produced higher returns, they wouldn’t be riskier! The correct formulation is that in order to attract capital, riskier investments have to offer the prospect of higher returns, or higher promised returns, or higher expected returns. But there’s absolutely nothing to say those higher prospective returns have to materialize.”

“Riskier investments are those for which the outcome is less certain. That is, the probability distribution of return is wider…The traditional risk/return graph is deceptive because it communicates the positive connection between risk and return but fails to suggest the uncertainty involved. It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money. I hope my version of the graph [see above] is more helpful. It’s meant to suggest both the positive relationship between risk and expected return and the fact that uncertainty about the return and the possibility of loss increase as risk increases.”

Howard Marks' Book: Chapter 5 - Part 1

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk” This is the first of three chapters to which Howard Marks dedicates to the topic of Risk. For those interested in Marks' thoughts on risk, these chapters are absolute must-reads.

Topics covered in this installment: Risk, Volatility

Risk, Volatility

“According to the academicians who developed capital market theory, risk equal volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition. It is my view that…academicians settled on volatility as the proxy for risk as a matter of convenience. They needed a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risk do not. The problem  with all of this, however, is that I just don’t think volatility is the risk most investors care about…I’ve never heard anyone at Oaktree – or anywhere else, for that matter – say, ‘I won’t buy it, because its price might show big fluctuations,’ or ‘I won’t buy it, because it might have a down quarter.’…To me, ‘I need more upside potential because I’m afraid I could lose money’ makes an awful lot more sense than ‘I need more upside potential because I’m afraid the price may fluctuate.’”

To be fair, Oaktree and most private equity investors have semi-permanent long-term capital (thanks to the lock-up terms). Most public market fund managers do not have this luxury, and are more vulnerable to the vagaries of short-term volatility that can lead to other types of risks such as “underperformance risk” and “career risk” (Marks discusses both later on). The public market fund managers themselves may not fear volatility, but in the instance the underlying client base loses patience and demands the return of capital via redemptions, volatility becomes a very real risk in the form of permanent impairment of capital.

Risk

“…hopefully we can agree that losing money is the risk people care about most…An important question remains: how do they measure that risk? First, it clearly is…a matter of opinion: hopefully an educated, skillful estimate of the future, but still just an estimate. Second, the standard for quantification is nonexistent. With any given investment, some people will think the risk of high and others will think it is low.”

“…risk and the risk/return decision aren’t ‘machinable,’ or capable of being turned over to a computer…Ben Graham and David Dodd put it this way more than sixty years ago…‘the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulations.’”

“The bottom line is that, looked at prospectively, much of risk is subjective, hidden, and unquantifiable. Where does that leave us? If the risk of loss can’t be measured, quantified or even observed – and if it’s consigned to subjectivity – how can it be dealt with? Skillful investors can get a sense for the risk present in a given situation…There have been many efforts of late to make risk assessment more scientific. Financial institutions routinely employ quantitative “risk managers” separate from their asset management teams and have adopted computer models such as “value at risk” to measure the risk in a portfolio…In my opinion, they’ll never be as good as the best investors’ subjective judgment.”

Qualitative vs. Quantitative. Both worthy adversaries, each camp with its prolific heroes.

It’s likely that successful quantitative investors (such as David E. Shaw who utilize computerized risk optimizers) would disagree with Marks’ statement above, that risk management entails more art than science. But the secretive nature of their algorithms and risk models make it difficult to comprehend how the successful quants are able to quantify risk via “machinable” methodologies contrary to the opinions of Howard Marks, Ben Graham, and David Dodd.

Howard Marks' Book: Chapter 4

Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 4 “The Most Important Thing Is…The Relationship Between Price and Value.” Topics covered: Volatility, Leverage, When To Buy, When To Sell  

Volatility

“…most of the time a security’s price will be affected at least as much – and its short-term fluctuations determined primarily – by two other factors: psychology and technicals…These are nonfundamental factors – that is, things unrelated to value – that affect the supply and demand for securities.”

“Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals…The key is who likes the investment now and who doesn’t. Future price change will be determined by whether it comes to be liked by more people or fewer people in the future.”

“For self-protection, then, you must invest the time and energy to understand market psychology. It’s essential to understand that fundamental value will be only one of the factors determining a security’s price on the day you buy it. Try to have psychology and technicals on your side as well.”

Many investors suffer the vicissitude of volatility and deny they are suffering by clinging to the excuse that short-term price fluctuations are merely temporary impairments of capital.

The movements may be temporary, but temporary movements downward still impact your performance trackrecord, capital reinvestment options, etc., and therefore should not be completely ignored.

Howard Marks is undoubtedly a long-term investor, yet he considers the causes and ramifications of volatility “for self-protection.” Afterall, investing is difficult enough, wouldn’t you rather (attempt to) avoid the headwind of downside volatility if and when possible?

Leverage

“Here the problem is that using leverage – buying with borrowed money – doesn’t make anything a better investment or increase the probability of gains. It merely magnifies whatever gains or losses may materialize. And it introduces the risk of ruin if a portfolio fails to satisfy a contractual value test and lenders can demand their money back at a time when prices and illiquidity are depressed. Over the years leverage has been associated with high returns, but also with the most spectacular meltdowns and crashes.”

What about non-recourse debt? (Ethics aside, of course.) Could non-recourse debt make an investment “better” by skewing the ratio of potential loss (your equity cost basis) vs. potential gain?

When To Buy

“No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.”

“Believe me, there is nothing better than buying from someone who has to sell regardless of price during a crash. Many of the best buys we’ve ever made occurred for that reason.”

“The safest and most potentially profitable thing is to buy something when no one likes it.”

Before buying a security, consider who is selling and reasons why the seller dislikes it enough to sell. The best buying situations involve discoveries of forced/indiscriminate sellers for XYZ reason(s).

When To Sell, When To Buy

“Since buying from a forced seller is the best thing in our world, being a forced seller is the worst. That means it’s essential to arrange your affairs so you’ll be able to hold on – and not sell – at the worst of times. This requires both long-term capital and strong psychological resources.”

“A ‘top’ in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments.”

“Well bought is half sold.”

There’s an inherent, inseparable relationship between the act of buying and selling a security.

Howard Marks' Book: Chapter 3

Below is a continuation of portfolio management highlights from Howard Marks’ recent book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 3 “The Most Important Thing Is…Value”: For anyone who has purchased a security too soon while the price continued to decline, I would highly recommend reading the last few pages of Chapter 3 in its entirety.

Intrinsic Value

“To value investors, an asset isn’t an ephemeral concept you invest in because you think it’s attractive (or think others will find it attractive). It’s a tangible object that should have an intrinsic value capable of being ascertained, and if it can be bought below its intrinsic value, you might consider doing so. Thus, intelligent investing has to be built on estimates of intrinsic value. Those estimates must be derived rigorously, based on all of the available information.”

“…the best candidate for that something tangible is fundamentally derived intrinsic value. An accurate estimate of intrinsic value is the essential foundation for steady, unemotional and potentially profitable investing.”

Intrinsic value is tangible. But does “tangible” and “capable of being ascertained” mean an exact calculated estimation, or is the triangulation of a range considered a good enough estimation of intrinsic value?

The derivation of intrinsic value involves a process, and it is this process as well as the estimation of intrinsic value that injects discipline and governs a number of complex (and often potentially emotionally charged) investment decisions such as when to buy, when to sell, knowing when you’re wrong, etc.

Making Mistakes, When To Buy, When To Sell

“…in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away…”

“…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.’”    

“…very difficult to hold, and to buy more at lower prices (which investors call ‘averaging down’), and especially if the decline proves to be extensive. 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.”

“An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse.”

Being “right” versus “wrong” can sometimes simply involve a debate of time semantics.

Dealing with a mistake is often extra difficult because of the behavioral aspects that an investor must overcome, such as self-doubt.

The solution circles back to the idea of process over outcome. An investor can’t control the timing of outcome (price movement), but he/she can control the investment process. So when doubt and other negative emotions reign supreme, the only antidote is to reexamine your process and estimation of intrinsic value.

In the last sentence, Marks cautions against “an incorrect opinion…strongly held.” Behavioral finance calls it “anchoring.” Poker calls it “pot commitment.” Equally important as the reexamination of your investment process and intrinsic value, is the possession of the wisdom to know when to fold a hand, especially when an “incorrect opinion” has occurred.

When To Sell

“Momentum investing might enable you to particulate in a bull market that continues upward, but I see a lot of drawbacks. One is based on economist Herb Stein’s wry observation that ‘if something cannot go on forever, it will stop.’ What happens to momentum investors then? How will this approach help them sell in time to avoid a decline?”

Some say the curse of value investing is that this breed often misses out on the “momentum effect” by selling positions too soon, and that their portfolios fail to participate in raging bull markets.

Howard Marks offers some word of consolation by advising value investors to observe process over outcome, and to not cry over the spilt milk of missing the momentum effect.

Sizing

“Compared to value investing, growth investing centers around trying for big winners. If big winners weren’t in the offing, why put up with the uncertainty entailed in guessing at the future? There’s no question about its: it’s harder to see the future than the present. Thus, the batting average for growth investors should be lower, but the payoff for doing it well might be higher. The return for correctly predicting which companies will come up with the best new drug, most powerful computer or best-selling movies should be substantial.”

Howard Marks astutely commented that the reconciliation between value and growth investing lies in the difference “between value today and value tomorrow.” Is there another possible source of reconciliation in sizing considerations?

The future is harder to predict, therefore the probability of positive outcome is lower for growth positions, while the absolute level of payout is higher. In certain instances, could a portfolio manager mitigate the risk of the lower probability of positive outcome by making the “growth” position a smaller percentage of the portfolio?

Howard Marks' Book: Chapter 2

Below is a continuation of portfolio management highlights from Howard Marks’ recent book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 2 “Understanding Market Efficiency (and It’s Limitation)”: Risk

“I have my own reservations about the theory [efficient market hypothesis], and the biggest one has to do with the way it links return and risk…Once in a while we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise. Those halcyon periods lull people into believing that to get higher returns, all they have to do is make riskier investments. But they ignore something that is easily forgotten in good times: this can’t be true, because if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier. Every once in a while, then, people learn an essential lesson. They realize that nothing – and certainly not the indiscriminate acceptance of risk – carries the promise of a free lunch, and they’re reminded of the limitations of investment theory.”

More Risk ≠ More Return

Psychology

“…one stands out as particularly tenuous: objectivity. Human beings are not clinical computing machines. Rather, most people are driven by greed, fear, envy and other emotions that render objectivity impossible and open the door for significant mistakes.”

Self-awareness. So important, yet again, so intangible – just like the creativity component.

I often tell people that half the investment battle actually takes place in your mind, not the marketplace. Controlling your bias, fears, vanity (my favorite, and most deadly investing original sin “I’m right, the market is just stupid.”), etc. takes an incredible amount of discipline. But before discipline can work its magic, self-awareness must first exist to identify the problem.

Howard Marks' Book: Chapter 1

In his recent book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Howard Marks of Oaktree writes about a lot of different investment topics. I’ve done my best to lift out relevant portfolio management details. Without further ado, below are highlights from Chapter 1, titled “The Most Important Thing Is…Second-Level Thinking.” Portfolio Management

“Because investing is at least as much art as it is science, it’s never my goal – in this book or elsewhere – to suggest it can be routinized. In fact, one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.”

Successful investing involves equal parts sniffing out ideas, effective diligence, and thoughtful portfolio management. Marks’ comments may not have been written to pertain specifically to the portfolio management process, but it certainly applies.

It’s difficult to routinize portfolio management since the process differs by person and by strategy. Tug on one side of the intricate web and you change the outcome in several other areas. Portfolio management, like the “investing” in Marks’ words, is an art, not the science – distilled into a perfectly eloquent formula or model as many academics and theorists have attempted to extract. (Ironically, Howard Marks and I were both educated at the University of Chicago.) Art demands some degree of inherent messiness – constant changes, tweaks, paint everywhere. Art, like portfolio management, requires practice, dedication, and reflection over time.

Creativity

“No rule always works…An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness.”

“Unconventionality shouldn’t be a goal in itself, but rather a way of thinking. In order to distinguish yourself from others, it helps to have ideas that are different and to process those ideas differently.”

Investment performance is ever forward looking. A strategy or idea that’s worked in the past may or may not provide the same success in the future. Marks’ comments regarding the importance of creativity have broad applications – from idea sourcing to the diligence process to portfolio management technique.

Maintaining that creative spirit, staying one step ahead of the competition (sounds oddly like running a business, doesn’t it?) is crucial to generating superior investment returns over the long run.

Definition of Investing, Benchmark

“In my view, that’s the definition of successful investing: doing better than the market and other investors.”

Here, the definition of successful investing depends upon “doing better than” a certain “market” or “other investors.”

In order to “do better” than something, an investor must identify that something ahead of time – whether it be a single market index or a bundle of indices and other competing funds.

We’ve discussed the topic of benchmarks in the past (see benchmark tag). For example, during the Partnership days, Buffett used the Dow as his primary benchmark, but also showed investors his performance against a group of well-known mutual and closed end funds. Some Brazilian hedge funds use the local risk-free-rate as their benchmark.

The point is: your choice of benchmark can vary, just make sure that you’ve at least made a choice.