“The easy money has been made” is one of my least favourite sayings about investing.
Making money in the markets is never easy. In fact, I would argue that it’s always hard.
Convincing yourself to buy during a bear market is hard. Convincing yourself to hold during a bull market is hard. Figuring out what to do during a sideways market is hard. Watching others make more money in the markets than you is hard. Following a plan when things aren’t going your way is hard. There’s always going to be a reason to do something that goes against your best interests.
Howard Marks wrote about this idea in a memo for Oaktree Capital a couple years ago:
Two of the main reasons people sell stocks is because they go up and because they go down. When they go up, people who hold them become afraid that if they don’t sell, they’ll give back their profit, kick themselves, and be second-guessed by their bosses and clients. And when they go down, they worry that they’ll fall further.
Where we are in each cycle usually determines what the hard part is at that moment. The hardest part for the past few years has been holding on during a rising market. Investors witnessed two epic market crashes in the span of eight years to kick off the start of the century. Those types of losses leave scars on an investor’s psyche.
When I was younger I would immediately take big positions. If I liked something, I would go all in. I was fearless.
This strategy worked until it didn’t.
Today I buy a third to a half of a full position after due diligence and I’ll add more as management executes. Inexperience almost always underestimates risk. The more you experience the more you respect what you are up against.
But it’s a balancing act.
Investing’s greatest lessons can’t be taught in a book or in a classroom. They have to be experienced and often times the teacher is loss. And losses can be painful.
The most painful part of loss isn’t financial but mental. The battle scars left behind can paralyze you. The spirit of courage you were born with turns to fear. Fear slows you down. Indecision can be an investors biggest adversary.
I am fascinated with history, or more specifically, market history and how investors reacted during different periods of different markets cycles.
Partly because I’m interested in history and partly because I want to be prepared for every market environment, I like to seek out investor letters and commentary from some of the best investors of all time during periods of market stress, such as the dot-com bubble or financial crisis.
Howard Marks (Trades, Portfolio) is undoubtedly one of the best commentators in this regard. His regular memos to investors have maintained the same investing framework ever since he started writing them in 1990. All that has changed during this period is the market environment. That’s very clear throughout the letters as Marks applies his cool, value-focused mind to every climate no matter what the prevailing consensus among Wall Street analysts.
The dot-com bust
I recently stumbled across one of Marks’ memos from 2000. Titled “We’re Not In 1999 Anymore, Toto,” the letter is a perfect example of Marks’ investing style. Just after the dot-com bubble had burst, the highly acclaimed billionaire uses the memo to provide a post-mortem on the market environment, and a look at what went wrong, as well as what went right.
One of our favorite investing books here at The Acquirer’s Multiple is The Most Important Thing by Howard Marks.
There’s one passage in particular in which Marks discusses how keeping one’s ego in check is the greatest formula for long-term wealth creation. Here’s an excerpt from the book:
The sixth key influence is ego. It can be enormously challenging to remain objective and calculating in the face of facts like these:
One of our readers shared the transcript of a roundtable talk among Seth Klarman, David Abrams, and Howard Marks almost 10 years ago. It is a very long read (22 pages) but if you’d like to learn about these great value investors and their investment approaches, it is a great read. I will share some excerpts from each of these investors and share the link at the bottom of this article. Here is how Seth Klarman summarized what Baupost does:
“In terms of investing I would say that there is no exact formula for what we do. We try to use all the value investing principles we know. The world is imperfect. The world doesn’t just dish up net, nets all the time. The world doesn’t dish up stocks trading below cash all the time, doesn’t deliver fine businesses at eight times earnings all the time. So we look very hard for mis-pricings, for information asymmetries. for supply/demand imbalances, and we find ourselves at various times heavily in distress debt or no position in distress debt, significantly involved in equities and uninvolved in equities, very focused on private markets or uninvolved because you can create the same assets cheaper in the public market. So in a nutshell that’s our approach. Very opportunistic. We try to be not siloed the way many people are. We don’t have industry analysts we have generalists who can move quickly from working one day on a drug stock to another day on the distress debt of a bank, and another day even potentially on a mortgage security or real estate investment. That’s not easy but it does provide constant stimulation, a lot of cross-training, which people enjoy, and it also means that our resources will always be deployed in the most interesting areas all the time. So that’s Baupost in a nutshell.”
When we find an attractive stock to invest in, we outlay money, aka invest, to earn an attractive return and the investment will involve a degree of risk.
One of the most dangerous, commonly accepted and ill thought out concepts in investing is the risk / return trade off.
That is: high returns equals high risk.
Unfortunately, Investopedia continues to spread this type dogma, as you can see by the graph below.
Volatility (standard deviation) is not risk!
The appropriate definition of risk is from the Oxford dictionary (or any other branded non-financial dictionary) as: Exposure (someone or something valued) to danger, harm, or loss.
In late July, Oaktree Capital’s Howard Marks put out a memo describing current investment trends that could turn out to be mistakes. Marks urged caution on equity valuations, low volatility, FAANG stocks (Facebook, Amazon, Apple, Netflix and Google), ETFs, interest rates, private equity, venture capital and even bitcoin.
Caution alone is not an investment strategy, so Marks penned a follow-up memo last week to give investors six options for how to invest in a low-return world:
And here’s how he would proceed, given today’s choices:
“There is one other rule you ought to keep in mind and that is to concentrate, and not only in the Zen sense. Sweet are the uses of diversity, but only if you want to end up in the middle of an average” Adam Smith, the Money Game
“Statistical analysis shows that security-specific risk is adequately diversified after 14 names in different industries, and the incremental benefit of each additional holding is negligible. We own 18-22 companies to allow us to be amply diversified but have the flexibility to overweight a name or own more than one business within an industry.” Mason Hawkins
“Empirical testing has proved beyond a reasonable doubt that the “riskiness” of a portfolio of 12-15 diverse companies is little greater than one loaded with a hundred or more” Frank Martin
“If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don‘t diversify personally. ” Warren Buffett
In August, I mentioned that I had chosen the title “Political Reality” for my memo in part because of my liking for oxymorons. I classed that title with other internally contradictory statements, such as “jumbo shrimp” and “common sense.” Now I’m going to discuss one more: “expert opinion.”
This memo was inspired by a thought that popped into my head when the outcome of the election settled in. You may point out that at the end of my November 14 memo “Go Figure!,” I said I wouldn’t write any more about politics. True, but I didn’t say I wouldn’t think about politics. Anyway, this memo isn’t about politics, it’s about opinions.
Last spring I attended a dinner where one of Hillary Clinton’s senior advisers was soliciting input, as she and her campaign were struggling to come up with an effective counter to Bernie Sanders’s populist message. Most of those present expressed frustration on the subject, until an experienced, connected Democrat assured everyone, “Don’t worry. She’ll win. The math is irresistible.” The Hillary supporters were relieved, and he turned out to be right: she won the nomination going away.
In late October, with the issue of Clinton’s private email server and the FBI’s new investigation further dogging her, that same seasoned Democrat was asked whether the election was in jeopardy. “Don’t worry,” he said. “She’ll win. The math is irresistible.” We all know the result.