Saturday, July 23, 2011

The Most Important Thing: Chapters 15 and 16

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.

Since we can't know the future, we should have a good understanding of the present. Marks is a proponent of "taking the market's temperature". If the market is too hot, investors (as contrarians) should be wary of entering and should seek to exit. If the market is cold, investors should look to jump in. Marks lists a number of signs investors should look for to gauge market sentiment.

He uses some of these signs to show the market's "temperature" in 2007 before the crash. For example, there was a belief that real-estate prices could never fall, creditors were issuing record amounts of debt and demanding little in the way of spreads or security, and buyouts were being completed at higher and higher multiples of cash flow (higher than they were in 2001, for example).

Marks also warns about the role of luck in investing, particularly in the short-term. You can't tell the difference between a good money manager and a poor one over short periods of time, because there is so much randomness in market prices over periods as long as years. Marks references Buffett's tale of the 2 million people who flipped coins, where after 15 flips, there were a number of people that had flipped 15 heads in a row. These people would write books about flipping techniques that others would lust after, even though it was all due to luck. Marks also frequently references the ideas espoused by the book Fooled by Randomness, which is summarized here.

Investors who recognize that the future is difficult to predict will construct portfolios based on the present and knowable, whereas most investors have an idea of what the future will look like and construct their portfolios accordingly. Marks argues that the latter group is doomed to failure over the long-term, since the future is not knowable but a probability distribution. Those who construct their portfolios defensively with the understanding that if things don't go as planned they will still be okay, stand to outperform.

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