Sunday, July 10, 2011

The Most Important Thing: Chapters 9 and 10

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.

Though market prices may be right "on average", this doesn't adequately describe investor sentiment at any one time. Marks describes investor sentiment as that mimicking a pendulum. While the pendulum may be in the middle "on average", it spends a lot of time moving away from the average toward the extremes.

The pendulum swings describe the risk appetite of the market. When investors are greedy, they don't ask for much in return for the risk they take on. When investors are fearful, they avoid risk even when they are being paid handsomely to take it on. And yet mainstream finance argues that investor risk aversion is some constant presence.

Marks then goes into a discussion about bubbles and crashes. He draws on a few other authors who have studied these phenomena, including John Kenneth Galbraith, who describes "the extreme brevity of the financial memory". When bubbles are forming, a number of human emotional traits take over to remove rationality. Investors drop their independence in the face of herd-like crowds (as demonstrated in the Asch experiments) and become part of the crowd. These end in crashes where many lose everything.

To avoid falling prey to the same psychology as the market, Marks has a few recommendations for investors. First, they need a strongly held sense of the intrinsic value of every security in their portfolio. Then, they must insist on acting as they should; that is, they should buy as the price deviates significantly from intrinsic value. Investors should also have an understanding of past cycles and past pendulum swings, to have a long-term view of what may be occurring in the present. Finally, investors need to have a willingness to look wrong while the market goes from misvalued to even more misvalued.

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