In the updated version of The Most Important Thing, Howard Marks, Seth Klarman, Joel Greenblatt, and others have their comments interspersed throughout the already great text.
The added comments are instructive. Marks takes a unique approach by breaking down his comments into four themes that run throughout the book — the riskiest things being one.
Most of his riskiest things revolve around behavior and ignoring imbalances in the market (there is some overlap too). The point: If you can recognize and avoid the riskiest things in investing, you’ll save yourself from a lot of pain and misery.
1. Paying for Perfection
The biggest losers — be they Nifty-Fifty stocks in 1969, internet stocks in 1999, or mortgage vehicles in 2006 — had something in common; no one could find a flaw. There are lots of ways to describe this condition: “priced for perfection,” “on the pedestal of popularity,” and “nothing can go wrong.” Nothing’s perfect, however, and everything eventually turns out to have flaws. When you pay for perfection, you don’t get what you expected, and the high price you pay exposes you to risk of loss when reality comes to light. This is truly one of the riskiest things.
Paying for perfection leaves no room for error. You’re essentially buying at the height of popularity so good news is priced in, as is great expectations. Everything has to go right to make money. A single slip up by management, a market share boost to competitors, or simply falling short of market expectations means you lose…sometimes a lot.
2. Paying for Optimism
The most dangerous investment conditions generally stem from psychology that’s too positive. For this reason, fundamentals don’t have to deteriorate in order for losses to occur; a downgrading of investor opinion will suffice. High prices often collapse of their own weight.
Ben Graham said in the short term, the stock market is a voting machine. In the long term, it’s a weighing machine. Mood drives price more than fundamentals in the short run and mood swings can happen on a whim…even though fundamentals don’t change much.
3. Paying a Too High Price
The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real.
It all starts with price. High prices lead to higher risk and lower (even negative) returns. So there are no bad assets, just bad prices. The risk is paying more for something than its worth.
4. Not Being Risk Averse
Too-high prices come from investor psychology that’s too positive, and too-high investor sentiment often stems from a dearth of risk aversion. Risk-averse investors are conscious of the potential for loss and demand compensation for bearing it — in the form of reasonable prices. When investors aren’t sufficiently risk averse, they’ll pay prices that are too high.
Successful investing is being aware of the potential risk that always exists with every investment. When you no longer worry about risk, it’s easy to think that no price is too high.
5. Believing Something is Without Risk
“There are few things as risky as the widespread belief that’s there’s no risk.” The opening words … are valuable because they highlight an excellent example of the ways investors’ behavior creates the risks to which they are subjected. When they swallow worry-free beliefs, it truly is the riskiest thing.
See #6.
6. Believing This Time is Different
A few times in my career, I’ve seen the rise of a belief that risk has been banished, cycles won’t occur any longer, or the laws of economics have been suspended. The experienced, risk-conscious investor takes this as a sign of great danger.
“This time is different” and “this investment is different” are interchangeable. Nothing has led to more lost money than the mistaken belief riskless investments exist. Anytime risk is discounted to oblivion, buyer beware.
7. Being Unconcerned About Risk
In the summer of 2009, the New York Times asked a dozen people to write about the causes of the crisis. My response … was entitled “Too Much Trust, Too Little Worry.” Take a look, and note that carefree, unworried investors are their own worst enemy.
A basic level of worry for loss keeps markets sane. Without worry — no fear of loss — then nothing is too risky, no price is too high, asset bubbles are likely, and the end result is devastating. Alternatively, an excess of worry is just as unhealthy.
8. Believing Risk is Static
When investors feel risk is high, their actions serve to reduce risk. But when investors believe risk is low, they create dangerous conditions. The market is dynamic rather than static, and it behaves in ways that are counterintuitive.
Marks calls this the “perversity of risk.” Believing risk never changes, that each investment has a fixed level of risk, is the wrong way to think about risk. Investor behavior changes, prices change, markets change, and with it, so does risk.
9. Believing Present Conditions Continue into the Future
When things are going well, extrapolation introduces great risk. Whether it’s company profitability, capital availability, price gains, or market liquidity, things that inevitably are bound to regress toward the mean are often counted on to improve forever.
Much like #6. There’s a long history of investors believing things will continue as they are — for businesses, markets, or economies. So far those who call the end of cycles has never been right. Extrapolating existing conditions far off into the future ignores the huge amount of uncertainty that comes with it and the long history of cycles.
10. Believing Things Only Get Better
The ultimate danger zone is reached when investors are in agreement that things can only get better forever. That makes no sense, but most people fall for it. It’s what creates bubbles — just as the opposite produces crashes.
See #6 and #9.
11. Being Unwilling to Look Dumb
Positive feelings — sometimes called animal spirits — are major contributors to asset overpricing. Disciplined value investors look like pessimists, grumps, or old fogeys … until they turn out to be among the few who protected against losses.
Anyone who bought internet stock in ’98 and ’99 looked like geniuses, while those that refused looked like idiots. But when the bubble burst, those roles reversed. Those that ignored the risk, suffered the most, while the “idiots” suffered the least. Refusing to join the herd and stick with your strategy, requires a willingness to look dumb in the short t
12. Not Being Aware of the Place in the Cycle
When buyers compete to put large amounts of capital to work in a market, prices are bid up relative to value, prospective returns shrink, and risk rises. It’s only when buyers predominate relative to sellers that you can have highly overpriced assets. The warnings signs shouldn’t be hard to spot.
Knowing what happens next is impossible, so the next best thing is to know where you are in the cycle now. This takes a lot of time and experience but pays off later with the ability to recognize risk from the behavior of other investors and prepare for it. Still, you must avoid being swept up in their behavior too.
13. Believing Not Missing Out is More Important Than Not Losing
A high level of belief and a corresponding low level of skepticism always play a large part in the ascent of prices that, afterward, everyone sees as having risen too high. Buying with borrowed money often increases the extent to which prices will become elevated, the likelihood of ensuing disaster, and the extent of the pain when it arrives. These are among the riskiest things.
The riskiest behavior always takes place at the peak of a cycle. When investors think prices can only go up and everyone else is getting rich quick, envy has a way of drawing you in. Not missing out becomes more important than not losing money. Leverage might get you to the get rich quick part sooner. It might also hasten getting poor. Leverage combined with the wrong short-term mood swing can completely wipe you out.
Related Reading:
Howard Marks: The Perversity of Risk
Howard Marks: The Importance of Second-Level Thinking
Howard Marks on Quantifying Risk
