Saturday, July 30, 2011

The Most Important Thing: Chapters 19 and 20

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.

In these, the final chapters of the book, Marks discusses the issue of adding value. Since anyone can generate average market returns by simply buying a passive index, the goal of investing is to generate alpha, or a spread between your returns and the market's return. Marks discusses how a portfolio of volatile stocks can appear to be generating alpha when the market is doing well, but this is simply beta, and investors shouldn't confuse the two. The problem with beta is that if the market goes down, so will the highly volatile stocks; therefore, beta cannot generate outperformance.

Marks reminds the investor that a year or two's worth of returns is not enough to determine if a manager has skill in outperforming the market. If the market had a good year, for example, it's possible that the manager was aggressively weighted towards riskier stocks. As such, his performance will tell you little about what may happen if the market were to collapse, as it does every so often.

For his firm, Oaktree, Marks prefers a defensive strategy whereby the portfolio barely keeps up when times are good, but outperforms when the market does poorly. Marks recommends investors select stocks with the same strategy in mind.

In the book's last chapter, Marks summarizes the lessons he has described in the book. He emphasizes employing a margin of safety, avoiding investing with the crowds, and knowing the value of what you have bought.

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