The Most Important Thing Illuminated by Howard Marks

I just finished reading my book "The Most Important Thing Illuminated" - by Howard Marks


Below are the summary of the book:

There are 20 important things of Investing highlighted by Howard in his book:

(1) Second-Level Thinking

(2) Understanding Market Efficiency (and Its Limitations)

(3) Value

(4) The Relationship Between Price and Value

(5) Understanding Risk

(6) Recognizing Risk

(7) Controlling Risk

(8) Being Attentive to Cycles

(9) Awareness of the Pendulum

(10) Combating Negative Influences

(11) Contrarianism

(12) Finding Bargains

(13) Patient Opportunism

(14) Knowing What You Don't Know

(15) Having a Sense for Where We Stand

(16) Appreciating the Role of Luck

(17) Investing Defensively

(18) Avoiding Pitfalls

(19) Adding Value

(20) Reasonable Expectations



Summary:

The best foundation for a successful investment - or a successful investment career - is value. You must have a good ideas of what the thing you're considering buying is worth. There are many components to this and many ways to look at it.

To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don't, see things differently or do a better job of analyzing them - ideally, all three.

Your view of value has to be based on a solid factual and analytical foundation, and it has to be held firmly. Only then will you know when to buy or sell. Only a strong sense of value will give you the discipline needed to take profits on a highly appreciated asset that everyone things will rise nonstop, or the guts to hold and average down in a crisis even as prices to lower every day. Of course, for your efforts in these regards to be profitable, your estimate of value has to be on target.

The relationship between price and value holds the ultimate key to investment success. Buying below value is the most dependable route to profit. Paying above value rarely works out as well.

What causes an asset to sell below its value? Outstanding buying opportunities exist primarily because perception understates reality. Whereas high quality can be readily apparent, it takes keen insight to detect cheapness. For this reason, investors often mistake objective merit for investment opportunity. The superior investor never forgets that the goal is to find good buys, not good assets.

In addition to giving rise to profit potential, buying when price is below value is a key element in limiting risk. Neither paying up for high growth nor participating in a "hot" momentum market can do the same.

The relationship between price and value is influenced by psychology and technicals, forces that can dominate fundamentals in the short run.

Extreme swings in price due to those two factors provide opportunities for big profits or big mistakes. To have it be the former rather than the latter, you must stick with the concept of value and cope with psychology and technicals.

Economies and markets cycle up and down. Whichever direction they're going at the moment, most people come to believe that they'll go that way forever. This thinking is a source of great danger since it poisons the markets, sends valuations to extremes, and ignites bubbles and panics that most investors find hard to resist.

Likewise, the psychology of the investing herd moves in a regular, pendulum-like pattern-from optimism to pessimism; from credulousness to skepticism; from fear of missing opportunity to fear of losing money; and thus from eagerness to buy to urgency to sell. The swing of the pendulum causes the herd to buy at high prices and sell at low prices. Thus, being part of the herd is a formula for disaster, whereas contrarianism at the extremes will help to avert losses and lead eventually to success.

In particular, risk aversion - an appropriate amount of which is the essential ingredient in a rational market - is sometimes in short supply and sometimes excessive. The fluctuation of investor psychology in this regard plays a very important part in the creation of market bubbles and crashes.

Most trends - both bullish and bearish - eventually become overdone, profiting those who recognize them early but penalizing the last to join. That's the reasoning behind my number one investment adage: "What the wise man does in the beginning, the fool does in the end." The ability to resist excesses is rare, but it's an important attribute of the most successful investors.

It's impossible to know when an overheated market will turn down, or when a downturn will cease and appreciation will take its place. But while we never know where we're going, we ought to know where we are. We can infer where markets stand in their cycle, from the behaviors of those around us. When other investors are unworried, we should be cautious; when investors are panicked, we should turn aggressive.

Buying based on strong value, low price relative to value, and depressed general psychology is likely to provide the best results. Even then, however, things can go against us for a long time before turning as we think they should. Underpriced is far from synonymous with going up soon. Thus the importance of my second key adage: "Being too far ahead of your time is indistinguishable from being wrong." It can require patience and fortitude to hold positions long enough to be proved right.

In addition to being able to quantify value and pursue it when it's priced right, successful investors must have a sound approach to the subject of risk. They have to go well beyond the academic' singular definition of risk as volatility and understand that the risk that matters most is the risk of permanent loss. They have to reject increased risk bearing as a surefire formula for investment success and know that riskier investments entail a wider range of possible outcomes and a higher probability of loss. They have to have a sense for the loss potential that's present in each investment and be willing to bear it only when the reward is more than adequate.

Most investors are simplistic, preoccupied with the chance for return. Some gain further insight and learn that it's as important to understand risk as it is return. But it's the rare investor who achieves the sophistication required to appreciate correlation, a key element in controlling the riskiness of an overall portfolio. Because of differences in correlation, individual investments of the same absolute riskiness can be combined in different ways to form portfolios with widely varying total risk levels. Most investors think diversification consists of holding many different things; few understand that diversification is effective only if portfolio holdings can be counted on to respond differently to a given development in the environment.

Oaktree's motto, "If we avoid the losers, the winners will take care of themselves," has served well over the years.

Risk control lies at the core defensive investing. Rather than just trying to do the right thing, the defensive investor places a heavy emphasis on not doing the wrong thing.

Risk control and margin for error should be present in your portfolio at all times. But you must remember that they're "hidden assets." Most years in the markets are good years, but it's only in the bad years - when the tide goes out - that the value of defense becomes evident. Thus, in the good years, defensive investors have to be content with the knowledge that their gains, although perhaps less than maximal, were achieved with risk protection in place...even though it turned out not be needed.

One of the essential requirements for investment success - and thus part of most great investors' psychological equipment - is the realization that we don't know what lies ahead in terms of the macro future. Few people if any know more than the consensus about what's going to happen to the economy, interest rates and market aggregates. Thus, the investor's time is better spent trying to gain a knowledge advantage regarding "the knowable": industries, companies and securities. The more micro your focus, the greater the likelihood you can learn things others don't.

An important pant of getting it right consists of avoiding the pitfalls that are frequently presented by economic fluctuations, companies' travails, the markets' manic swings, and other investors gullibility. There's no surefire way to accomplish this, but awareness of these potential dangers certainly represents the best starting point for an effort to avoid being victimized by them.

Another essential element is having reasonable expectations. Investors often get into trouble by acting on promises returns that are unreasonably high or dependable, and by overlooking the fact that, usually, every increase in return pursued is accompanied by an increase in risk borne. The key is to think long and hard about propositions that may be too good to be true.

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.