Saturday, July 2, 2011

The Most Important Thing: Chapters 1 and 2

Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.

According to Marks, investing is more art than it is science. As such, successful investors aren't the ones with the fastest computers or the quickest trigger fingers, but rather those with superior insight. Marks calls this "second-level thinking".

For example, first-level thinking may say: "The sector is strengthening, therefore this stock will go up." Second-level thinking goes beyond what is already out there. Second-level thinkers may say: "The sector is expected to go up and therefore the stock price is high; time to sell."

Many aspects of second-level thinking can't be taught, Marks argues. As in basketball, you can't coach height. Therefore, even most of those exposed to world-class educations in economics and accounting will be limited by a lack of insight that relegates them from being superior investors. To beat the market, one has to not only have non-consensus views, but be correct about them more often than not. This is very difficult.

On efficient markets, Marks does concede that many asset classes are efficiently priced most of the time. He discusses some criteria that lead to the relative pricing efficiency or inefficiency of assets/sectors.

But in many cases, prices are not efficient. They may react quickly to news, but that doesn't mean the consensus price reaction was correct in direction and magnitude. For example, Yahoo traded at $237 in January of 2000 and $11 in April of 2001; the market could not have been right about the price in both cases.

The fact that there is some inefficiency offers investors the chance to both win or lose in the market. The fact that investors can lose from an inefficient market is often neglected. Those with superior insight can beat the market, but there will be losers in this zero-sum game.

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