Investing consists of exactly one thing: dealing with the future.

-Howard Marks

Several years ago I was introduced to the writings of Howard Marks and have been a loyal follower ever since. The reflections he shares in his memos, while occasionally written from the perspective of a value investor, offer insights and reasoning that are applicable to many different fields of investing and life. I consider his memos to be essential reading, and The Most Important Thing acts as an excellent companion piece with additional thoughts and commentary. Below I’ve highlighted a few topics that I thought were worth a discussion

Market Efficiency
Marks has a nuanced opinion on market efficiency. He holds the view that asset prices may be quick to incorporate all available information. However, the resulting consensus view that is reflected in the price of an asset may not be correct. Why would prices not be correct? Humans are prone to misjudgement and psychological biases–we aren’t always objective. But the psychological factors that cause assets to be mispriced may also work against those looking to take advantage of said mispricings

The bottom line for me is that, although the more efficient markets often misvalue assets, it’s not easy for any one person–working with the same information as everyone else and subject to the same psychological influences–to consistently hold views that are different from the consensus and closer to being correct. [1a]

There’s a practical consequence to the efficient market debate that I think often gets ignored. It’s not whether the market is efficient or not, or to what degree. The real question we should probably be asking: How does market efficiency inform investment decisions? The market may not be efficient, but taking advantage of inefficiencies in a consistently profitable manner, as Marks suggests, is extremely difficult. Strict value investing isn’t for everyone.

One alternative to searching for mispriced assets would be to invest as though the market were efficient using passive index or index-like products. Historically speaking these types of asset allocation strategies have worked very well for individual investors. Extremely low fees, broad diversification and the elimination of many psychological issues that arise when attempting to value individual assets–all good things that are difficult to argue with.

Risk
Another important outcome of efficient market theory is the explanation of return premia. In a truly efficient market investment skill does not exist, and any differences in portfolio returns are a consequence of the differences in risk that a given portfolio is exposed to. In other words excess returns are compensation for bearing a larger amount of risk. Following this line of reasoning there must be a positive link between return and risk. This connection is the source of Marks’ biggest objection with efficient market theory

… if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier. [1b]

Simply taking on higher amounts of risk doesn’t necessarily lead to higher returns. Riskier assets attract capital by offering the potential for higher returns, but there’s no guarantee that those higher returns will materialize. Instead, Marks proposes a modification to the traditional risk-return relationship where larger amounts of risk create a wider range of possible outcomes. Below I back-tested this concept with volatility as the measure of risk

The idea that a wide range of outcomes is possible introduces uncertainty into the picture. Based on this notion riskier investments should involve the following:

• higher expected returns
• the possibility of lower returns
• in some cases the possibility of losses

He also eschews the idea that risk is equivalent to volatility. Instead risk is the likelihood of losing money (this is similar to the perspective of James Montier in his Seven Immutable Laws of Investing)

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.” [1c]

In a more pragmatic way this risk of permanent loss may be seen in the price of an asset. If an asset is overpriced it is more likely to decline in value and lead to a loss. High risk and low prospective returns are synonymous, and both come about through high prices.

Knowing what you don’t know
After several years of managing my own investments I am convinced that a high degree of humility and honesty with oneself are required to be successful. Fooling yourself into thinking that you were correct when you were clearly wrong only hurts the future you. Marks references this excellent quote from Mark Twain

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. [1d]

For me the most obvious application of this idea applies to forecasting the future. Humility aside, the other thing that I am one-hundred percent convinced of is that the future cannot be predicted. Certitude is something that is incredibly difficult, if not impossible, to come by when dealing with financial markets.

Second level thinking
Marks refers to deep thought as second level thinking–a means to achieve superior insight by thinking differently. But thinking in a different way alone is insufficient

Second level thinking is deep, complex and convoluted. [1e]

Second level thinking is something, admittedly, that I could do a better job at. This particularly applies to understanding “why” things happen in financial markets. More often than not this is a very difficult question to answer because: there may be multiple “correct” answers, or the true reason is blurred or unknowable. Asking “why” is still a worthy pursuit as the question isn’t so much about arriving at an answer–it’s very much about the journey and the things learned along the way. Here’s a few questions I thought of to help improve my own second level thinking

• Why?
• How can this be explained?
• How can this go wrong?
• What are the consequences if it does go wrong?

As I read this book it was readily apparent that Marks thinks in a much different manner and on a much deeper level than most investors. The entire book, and Marks’ memos for that matter, are a massive exercise in second level thinking.

References
1. Marks, Howard. The Most Important Thing Illuminated. Columbia University Press. New York, NY. 2013.
(a) p. 10
(b) p. 12
(c) p. 44
(d) p. 150
(e) p. 4

NOTES – The Most Important Thing.pdf

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What I’m Reading
Long-Term Bonds Behave More Like Stocks Than You Might Think (Lawrence Hamtil), also see…
Predicting Forward 60/40 Returns (Jake at EconomPic)
Is the American Public Corporation in Trouble? (Kathleen Kahle and René Stulz)
podcast: Invest Like the Best: Patrick O’Shaughnessy interviews Josh Brown