Howard Marks on second level thinking, the role of luck & taking the market’s temperature

Howard Marks is the Chairman and cofounder of Oaktree Capital Management and author of The Most Important Thing: Uncommon Sense for the Thoughtful Investor. According to the book’s sleeve, he is renowned for his insightful assessments of market opportunity and risk. He is sought out by the world’s leading investors, and his client memos brim with astute commentary and time tested fundamental philosophy. On a more personal note he’s one of my investing heroes. A value investor at heart, his broad thinking and eloquent expression is pertinent to anyone with investment and business interests both professional and personal. In keeping with the theme of this blog, I’ve chosen three of my favourite things with a nod towards to the entrepreneurial thinker: the importance of second level thinking, the role of luck in success & having a sense for where we stand.

The Most Important Thing Is… Second Level Thinking

On the basis that anyone can invest in an index fund and achieve market returns, Marks views the definition of investment success as being the ability to ‘beat the market’. To accomplish that, you need either good luck or superior insight. However, counting on luck isn’t much of a plan, so his advice is to concentrate on insight. And since other investors may be smart, well-informed and highly computerised, you must find an edge that they don’t have. Marks provides a simple matrix that positions second level thinking:

He also provides a list of the great many things that a second level thinker should take into account:

  • What is the range of likely future outcomes?
  • Which outcome do I think will occur?
  • What’s the probability I’m right?
  • What does the consensus think?
  • How does my expectation differ from the consensus?
  • How does the current price for the asset comport with the consensus view of the future, and with mine?
  • Is the consensus psychology that’s incorporated into the price too bullish or bearish?
  • What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

The upshot is simple: to achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be right. That’s not easy… The good news is that the prevalence of first level thinkers increases the returns available to second level thinkers. To consistently achieve superior investment returns, you must be one of them.

That is also a great list of questions for the an entrepreneur, for whom ultimate success can only lie in combining unconventional behaviour with favourable outcomes. It boils down to the need to think and act like a contrarian. After all, logic dictates that if you follow the crowd then you can’t beat the crowd. As Marks says “you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” The best entrepreneurs do all three, and they’re right!

The Most Important Thing Is… Appreciating the Role of Luck

Marks is a keen follower of Nassim Taleb, whose ideas he says he finds novel and provocative. He quotes Taleb’s book Fooled By Randomness at the start of the chapter on luck:

Randomness (or luck) plays a huge part in life’s results, and outcomes that hinge on random events should be viewed as different from those that do not… Clearly my way of judging matters is probabilistic in nature; it relies on the notion of what could have probably happened… If we have heard of [history’s great generals and inventors], it is simply because they took considerable risks, along with thousands of others, and happened to win. They were intelligent, courageous, noble, had the highest possible obtainable culture in their day – but so did thousands of others who live in the musty footnotes of history.

This is Taleb’s idea of ‘alternative histories’ – other things that could have happened just as easy as the ‘visible histories’ (i.e. noteworthy events) that did. Marks sees this as particularly relevant to investing:

The fact that a strategem or action worked – under the circumstances that unfolded – doesn’t necessarily prove the decision behind it was wise. Maybe what ultimately made the decision a success was a completely unlikely event, something that was just a matter of luck. In that case, that decision – as successful as it turned out to be – may have been unwise, and the many other histories that could have happened would have shown the error of the decision.

All told, Marks encourages the reader to remember that:

Every once in a while, someone makes a risky bet on an improbable or certain outcome and ends up looking like a genius. But we should recognise that it happened because of boldness, not skill… One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone. Few of these ‘geniuses’ are right more than once or twice in a row [Taleb refers to them as ‘lucky idiots’].

He also provides a fascinating anecdote on decision making which all of us should bear in mind when making hard choices:

The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that is optimal at the time it is made, when the future is by definition unknown. [It is] one that a logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known.

Having had this very conversation with a coaching client recently, a note of caution should go to entrepreneurial readers who concentrate their attention on individuals and their business success stories. The role of luck, combined with a story telling narrative fallacy (another Taleb coined term), can provide a potent illusion of preordained and planned success that overstates skill and understates the role of luck. The reality is far more complex.

 

The Most Important Thing Is… Having a Sense for Where We Stand

I’ve chosen this following hot on the heels of two recent memos from Howard and it’s pertinence to today’s markets. He published There They Go Again… Again in July 2017 in which he calls frothiness in the market, based on a combination of factors including low returns, high valuations and pro-risk behaviour. He quickly followed up with Yet Again? by way of riposte to the enormous amount of commentary that his previous memo had generated (including some interesting considerations on bitcoin, which Marks had initially criticised).

Whether you are investing or running a business, having a sense for the state of the market is essential. Fortunately, in the book Marks provides a rather wonderful template which he calls the Poor Man’s Guide to Market Assessment. His advice, if you find that most of your checkmarks are in the left-hand column, hold on to your wallet.

For what it’s worth, and no doubt making use of his own template, below are the four principal factors identified by Marks in his July 2017 memo There They Go Again… Again, with reference to the state of the current markets:

  • The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.
  • In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.
  • Asset prices are high across the board.  Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.
  • Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.

Also worth reading are his January 2000 memo bubble.com and February 2007 memo The Race to the Bottom which both proved prescient. Time will tell how prescient his most recent memo is.

Pulling It All Together

Marks takes the reader on a fascinating journey through the market environment in which investing takes place (and its ‘pendulum swings’ and cycles), then on to investors themselves and the (psychological) elements that affect their investment success or lack of it. He also spends a lot of time discussing risk and the importance of understanding, recognising and controlling it. Although not touched on in this post, for Marks, risk is the most interesting, challenging and essential aspect of investing. Another ‘important thing’ to think about.

He also recommends three books that have greatly influenced his investment philosophy and the book. They are:

A Short History of Financial Euphoria by John Kenneth Galbraith, which I read straight after this one. A wonderful little book, it is about the history of investment bubbles.

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Taleb, which I’ve not yet read. I have read the The Black Swan though which builds on the theme and I would highly recommend, if you can put up with Taleb’s irreverent style.

And Winning the Loser’s Game by Charles Ellis. Also not yet read by me but which comes highly recommended by many others, including Mr Marks himself. The go-to guide for the layman investor seeking to beat the market, it focuses on indexing your portfolio.

 

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Between now and the end of the year, I'm sharing fortnightly the wisdom that I have gained from my favourite recent reads, as it relates to life and business. The books I've chosen to summarise are: The Most Important Thing by Howard Marks, Superforecasting: The Art & Science of Prediction by Philip Tetlock, Team of Teams: New Rules of Engagement for a Complex World by General Stanley McChrystal, Coaching for Performance by Sir John Whitmore and Man's Search for Meaning by Viktor Frankl.

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