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A Few Notes on The Most Important Thing

June 23, 2011 • Posted in Investing Expertise, Sentiment Indicators

Howard Marks introduces his 2011 book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, by stating: “…I have built this book around the idea of the most important things–each is a brick in what I hope will be a solid wall, and none is dispensable. …I consider it my creed, and in the course of my investing career it has served like a religion. …You won’t find a how-to book here. There’s no surefire recipe for investment success. …Just a way to think that might help you make good decisions and, perhaps more important, avoid the pitfalls that ensnare so many. …the thing I most want to make clear is just how complex [investing] is.” Evolved from decades of investing experience, including that as co-founder and chairman of Oaktree Capital Management, some notable points from the book are:

From Chapter 1, “Second-Level Thinking” (Pages 2,6): “Investing, like economics, is more art than science. …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. …to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate.”

From Chapter 2, “Understanding Market Efficiency (and Its Limitations)” (Pages 14-15): “…we should assume efficiency will impede our achievement unless we have good reason to believe it will not in the present case. …The key turning point in my investment management career came when I concluded that…I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.”

From Chapter 3, “Value” (Page 21): “…the upside potential for being right about growth is more dramatic, and the upside potential for being right about value is more consistent. …In my book, consistency trumps drama.”

From Chapter 4, “The Relationship Between Price and Value” (Page 27): “Whereas the key to ascertaining value is skilled financial analysis, the key to understanding the price/value relationship…lies largely in insight into other investors’ minds.”

From Chapter 5, “Understanding Risk” (Page 39): “The bottom line is that, looked at prospectively, much of risk is subjective, hidden and unquantifiable.”

From Chapter 6, “Recognizing Risk” (Page 55): “Risk rises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns.”

From Chapter 7, “Controlling Risk” (Page 62): “Careful risk controllers know they don’t know the future. They know it can include some negative outcomes, but not how bad they might be, or exactly what their probabilities are.”

From Chapter 8, “Being Attentive to Cycles” (Page 69, 72): “The credit cycle deserves a very special mention for its inevitability, extreme volatility and ability to create opportunities for investors… Of all the cycles, it’s my favorite. …Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.”

From Chapter 9, “Awareness of the Pendulum” (Page 79): “…we never know: how far the pendulum will swing in its arc; what might cause the swing to stop and turn back; when this reversal will occur; or, how far it will then swing in the opposite direction.”

From Chapter 10, “Combating Negative Influences” (Page 85): “…thoughtful investors…avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check. This, in my opinion, is the greatest formula for long-term wealth creation…”

From Chapter 11, “Contrarianism” (Page 99): “Certain common threads run through the best investments I’ve witnessed. They’re usually contrarian, challenging and uncomfortable…by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left.”

From Chapter 12, “Finding Bargains” (Page 103): “…a bargain asset tends to be one that’s highly unpopular. Capital stays away from it or flees, and no one can think of a reason to own it.”

From Chapter 13, “Patient Opportunism” (Page 111): “You simply cannot create investment opportunities when they’re not there.”

From Chapter 14, “Knowing What You Don’t Know” (Pages 116-117 ): “The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. …we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. …investors should make an effort to figure out where they stand at the moment in terms of cycles and pendulums.”

From Chapter 15, “Having a Sense for Where We Stand” (Page 126): “We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future.”

From Chapter 16, “Appreciating the Role of Luck” (Page 140): “Given the highly indeterminate nature of outcomes, we must view strategies and their results–both good and bad–with suspicion until proved out over a large number of trials.”

From Chapter 17, “Investing Defensively” (Page 151): “For the thoughtful investor, …the answer is that defense can provide good returns achieved consistently, while offense may consist of dreams that often go unmet. For me, defense is the way to go.”

From Chapter 18, “Avoiding Pitfalls” (Page 164): “…avoiding pitfalls and acting on error aren’t susceptible to rules, algorithms or roadmaps. What I would urge is awareness, flexibility, adaptability and a mind-set that is focused on taking cues from the environment.”

From Chapter 19, “Adding Value” (Page 171): “…the performance of investors who add value is asymmetrical. The percentage of the market’s gain they capture is larger than the percentage of loss they suffer.”

From Chapter 20, “Putting It All Together” (Page 180): “Only investors with unusual insight can regularly divine the probability distribution that governs future events and sense when the potential returns compensate for the risks that lurk in the distribution’s negative left-hand tail.”

In summary, The Most Important Thing describes an investing approach based predominantly on guesstimating the state of highly indeterminate “cycles” or “pendulum swings” of investor sentiment.

See “Sentiment Indicators” for a collection of research on the effectiveness of sentiment metrics as investment/trading tools.

Reservations about the book include:

  • Citation of formal research in support of the beliefs presented is sparse.
  • Terms such as “creed,” “religion,” “more art than science” and “divine” suggest beliefs insusceptible (or a belief-holder resistant) to testing.
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