The Most Important Thing Illuminated

by Howard Marks

  JOEL GREENBLATT: Here is part of the tradeoff with diversification. You must be diversified enough to survive bad times or bad luck so that skill and good process can have the chance to pay off over the long term.

  Investors must brace for untoward developments. There are lots of forms of financial activity that reasonably can be expected to work on average, but they might give you one bad day on which you melt down because of a precarious structure or excess leverage.

  But is it really that simple? It’s easy to say you should prepare for bad days. But how bad? What’s the worst case, and must you be equipped to meet it every day?

  Like everything else in investing, this isn’t a matter of black and white. The amount of risk you’ll bear is a function of the extent to which you choose to pursue return. The amount of safety you build into your portfolio should be based on how much potential return you’re willing to forgo. There’s no right answer, just trade-offs. That’s why I added this concluding thought in December 2007: “Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in the good times, investors must choose between the two.”

  “THE AVIARY,” MAY 16, 2008

  The critical element in defensive investing is what Warren Buffett calls “margin of safety” or “margin for error.” (He seems to go back and forth between the two without making a distinction.) This subject deserves considerable discussion.

  JOEL GREENBLATT: “Margin of safety” and “Mr. Market” are the two ideas that Buffett refers to as Graham’s greatest contributions to the investing world.

  It’s not hard to make investments that will be successful if the future unfolds as expected. There’s little mystery in how to profit under the assumption that the economy will go a certain way and particular industries and companies will do better than others. Tightly targeted investments can be highly successful if the future turns out as you hope.

  But you might want to give some thought to how you’ll fare if the future doesn’t oblige. In short, what is it that makes outcomes tolerable even when the future doesn’t live up to your expectations? The answer is margin for error.

  HOWARD MARKS: Understanding uncertainty: Despite the presence of uncertainty, many investors try to select the ideal strategy through which to maximize return. But if instead we acknowledge the existence of uncertainty, we should insist on building in a generous margin of safety. That’s what keeps your result tolerable when undesirable outcomes materialize.

  Think about what happens when a lender makes a loan. It’s not hard to make loans that will be repaid if conditions remain as they are—e.g., if there’s no recession and the borrower holds on to his or her job. But what will enable that loan to be repaid even if conditions deteriorate? Once again, margin for error. If the borrower becomes jobless, the probability of the loan being repaid is greater if there are savings, salable assets or alternative sources of income to fall back on. These things provide the lender’s margin for error.

  The contrast is simple. The lender who insists on margin for error and lends only to strong borrowers will experience few credit losses. But this lender’s high standards will cause him or her to forgo lending opportunities that will go to lenders who are less insistent on creditworthiness. The aggressive lender will look smarter than the prudent lender (and make more money) as long as the environment remains salutary.

  SETH KLARMAN: This led one bank executive to comment in 2007 that “as long as the music is playing, you’ve got to get up and dance” (Citigroup CEO Charles Prince, Financial Times, July 9, 2007). The pressure to manage a company to increase near-term profits while keeping up with industry peers is one of the greatest problems with today’s business culture.

  The prudent lender’s reward comes only in bad times, in the form of reduced credit losses. The lender who insists on margin for error won’t enjoy the highest highs but will also avoid the lowest lows. That’s what happens to those who emphasize defense.

  CHRISTOPHER DAVIS: This is a complicated analogy, and I think problematic. In this scenario, what is the incentive for even conservative borrowers to do business with more conservative lenders? The incentive of a rational borrower is to seek the lowest rate without concern for the capability or prudence of the lender.

  Here’s another way to illustrate margin for error. You find something you think will be worth $100. If you buy it for $90, you have a good chance of gain, as well as a moderate chance of loss in case your assumptions turn out to be too optimistic. But if you buy it for $70 instead of $90, your chance of loss is less. That $20 reduction provides additional room to be wrong and still come out okay. Low price is the ultimate source of margin for error.

  CHRISTOPHER DAVIS: Also time—for instance, obsolescence risk.

  So the choice is simple: try to maximize returns through aggressive tactics, or build in protection through margin for error. You can’t have both in full measure. Will it be offense, defense or a mix of the two (and, if so, in what proportions)?

  Of the two ways to perform as an investor—racking up exceptional gains and avoiding losses—I believe the latter is the more dependable. Achieving gains usually has something to do with being right about events that are on the come, whereas losses can be minimized by ascertaining that tangible value is present, the herd’s expectations are moderate and prices are low. My experience tells me the latter can be done with greater consistency.

  A conscious balance must be struck between striving for return and limiting risk—between offense and defense. In fixed income, where I got my start as a portfolio manager, returns are limited and the manager’s greatest contribution comes through the avoidance of loss. Because the upside is truly “fixed,” the only variability is on the downside, and avoiding it holds the key. Thus, distinguishing yourself as a bond investor isn’t a matter of which paying bonds you hold, but largely of whether you’re able to exclude bonds that don’t pay. According to Graham and Dodd, this emphasis on exclusion makes fixed income investing a negative art.

  On the other hand, in equities and other more upside-oriented areas, avoiding losses isn’t enough; potential for return must be present as well. While the fixed income investor can pretty much practice defense exclusively, the investor who moves beyond fixed income—typically in search of higher return—has to balance offense and defense.

  The key is that word balance. The fact that investors need offense in addition to defense doesn’t mean they should be indifferent to the mix between the two. If investors want to strive for more return, they generally have to take on more uncertainty—more risk. If investors aspire to higher returns than can be achieved in bonds, they can’t expect to get there through loss avoidance alone. Some offense is needed, and with offense comes increased uncertainty. A decision to go that way should be made consciously and intelligently.

  Perhaps more than any other one thing, Oaktree’s activities are based on defense. (But not to the exclusion of offense. Not everything we engage in is a negative art. You can’t invest successfully in convertibles, distressed debt or real estate if you’re not willing to think about both upside and downside.)

  JOEL GREENBLATT: Investors think about this tension between risk and reward in conjunction with the probabilities of each. One way to maximize the asymmetry of risk and reward is to make sure you minimize risk. I’ve said this before in another place: if you minimize the chance of loss in an investment, most of the other alternatives are good.

  Investing is a testosterone-laden world where too many people think about how good they are and how much they’ll make if they swing for the fences and connect. Ask some investors of the “I know” school to tell you what makes them good, and you’ll hear a lot about home runs they’ve hit in the past and the home-runs-in-the-making that reside in their current portfolio. How many talk about consistency, or the fact that their worst year wasn’t too bad?

  One of the most striking things I’ve noted over the last thirty-five years is how brief
most outstanding investment careers are. Not as short as the careers of professional athletes, but shorter than they should be in a physically nondestructive vocation.

  Where are the leading competitors from the days when I first managed high yield bonds twenty-five or thirty years ago? Almost none of them are around anymore. And astoundingly, not one of our prominent distressed debt competitors from the early days fifteen or twenty years ago remains a leader today.

  Where’d they go? Many disappeared because organizational flaws rendered their game plans unsustainable. And the rest are gone because they swung for the fences but struck out instead.

  That brings up something that I consider a great paradox: I don’t think many investment managers’ careers end because they fail to hit home runs. Rather, they end up out of the game because they strike out too often—not because they don’t have enough winners, but because they have too many losers.

  CHRISTOPHER DAVIS: In equities, you can go too far, though—for instance, you can hide in investments perceived to be safe, thus avoiding controversy.

  And yet, lots of managers keep swinging for the fences.

  PAUL JOHNSON: I believe Marks’s observation is correct that many money managers are escorted from the business because their investment approach leads to too many failures.

  • They bet too much when they think they have a winning idea or a correct view of the future, concentrating their portfolios rather than diversifying.

  • They incur excessive transaction costs by changing their holdings too often or attempting to time the market.

  • And they position their portfolios for favorable scenarios and hoped-for outcomes, rather than ensuring that they’ll be able to survive the inevitable miscalculation or stroke of bad luck.

  At Oaktree, on the other hand, we believe firmly that “if we avoid the losers, the winners will take care of themselves.” That’s been our motto since the beginning, and it always will be. We go for batting average, not home runs. We know others will get the headlines for their big victories and spectacular seasons. But we expect to be around at the finish because of consistent good performance that produces satisfied clients.

  “WHAT’S YOUR GAME PLAN?” SEPTEMBER 5, 2003

  Figures 5.1 and 5.2 suggest there are gains to be had for assuming risk. The difference between the two figures, of course, is that the former doesn’t indicate the great uncertainty entailed in bearing increased risk, while the latter does. As figure 5.2 makes clear, riskier investments entail wider ranges of outcomes, including the possibility of losses instead of the hoped-for gains.

  Playing offense—trying for winners through risk bearing—is a high-octane activity. It might bring the gains you seek … or pronounced disappointment. And here’s something else to think about: the more challenging and potentially lucrative the waters you fish in, the more likely they are to have attracted skilled fishermen. Unless your skills render you fully competitive, you’re more likely to be prey than victor. Playing offense, bearing risk and operating in technically challenging fields mustn’t be attempted without the requisite competence.

  In addition to technical skills, aggressive investing also requires intestinal fortitude, patient clients (if you manage money for others) and dependable capital. When developments become adverse, you’ll need these things to get through. Investment decisions may have the potential to work out in the long run or on average, but without these things, the aggressive investor may not get to see the long run.

  Operating a high-risk portfolio is like performing on the high wire without a net. The payoff for success may be high and bring oohs and aahs. But those slipups will kill you.

  The bottom line on striving for superior performance has a lot to do with daring to be great. … One of the investor’s first and most fundamental decisions has to be on the question of how far out the portfolio will venture. How much emphasis should be put on diversifying, avoiding loss and ensuring against below-pack performance, and how much on sacrificing these things in the hope of doing better?

  I learned a lot from my favorite fortune cookie: The cautious seldom err or write great poetry. It cuts two ways, which makes it thought provoking. Caution can help us avoid mistakes, but it can also keep us from great accomplishments.

  Personally, I like caution in money managers. I believe that in many cases, the avoidance of losses and terrible years is more easily achieved than repeated greatness, and thus risk control is more likely to create a solid foundation for a superior long-term track record. Investing scared, requiring good value and a substantial margin for error, and being conscious of what you don’t know and can’t control are hallmarks of the best investors I know.

  “DARE TO BE GREAT,” SEPTEMBER 7, 2006

  PAUL JOHNSON: All investors should heed this advice.

  The choice between offense and defense, like so many in this book, defies an easy answer. For example, consider this conundrum: Many people seem unwilling to do enough of anything (e.g., buy a stock, commit to an asset class or invest with a manager) such that it could significantly harm their results if it doesn’t work. But in order for something to be able to materially help your return if it succeeds, you have to do enough so that it could materially hurt you if it fails.

  HOWARD MARKS: Fear of looking wrong: This dilemma shows how the fear of looking wrong interferes with implementing judgments and how hard it is to be a successful investor if you’re worried about appearances. Investment committees that behave “institutionally” do so for the simple reason that the pain associated with looking wrong is too great to bear. But the bottom line is simple and absolutely true: if you’re dominated by an unwillingness to be wrong, you’ll never be able to adopt the lonely, contrarian positions required for serious investment success.

  In investing, almost everything is a two-edged sword. That goes for opting to take bigger risks, substituting concentration for diversification and using leverage to magnify gains. The only exception is genuine personal skill. As for all the rest, if it’ll help if it works, that means it’ll hurt if it doesn’t. That’s what makes the choice between offense and defense important and challenging.

  Many see this decision as the choice between aspiring for more and settling for less. For the thoughtful investor, however, the answer is that defense can provide good returns achieved consistently, while offense may consist of dreams that often go unmet. For me, defense is the way to go.

  Investing defensively can cause you to miss out on things that are hot and get hotter, and it can leave you with your bat on your shoulder in trip after trip to the plate. You may hit fewer home runs than another investor … but you’re also likely to have fewer strikeouts and fewer inning-ending double plays.

  Defensive investing sounds very erudite, but I can simplify it: Invest scared!

  PAUL JOHNSON: I love this comment. I have met few investors who invest scared, except, of course, during a general market panic. But even in those cases they are not investing scared: they are no longer investing because they are too scared!

  Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high-quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing does go wrong, surely the winners will take care of themselves.

  “THE MOST IMPORTANT THING,” JULY 1, 2003

  18

  The Most Important Thing Is … Avoiding Pitfalls

  An investor needs do very few things right as long as he avoids big mistakes.

  WARREN BUFFETT

  PAUL JOHNSON: The Buffett quotation explains it all.

  In my book, trying to avoid losses is more important than striving for great investment successes. The latter can be achieved some of the time, but the occasional failures may be crippl
ing. The former can be done more often and more dependably … and with consequences when it fails that are more tolerable. With a risky portfolio, a downward fluctuation may make you lose faith or be sold out at the low. A portfolio that contains too little risk can make you underperform in a bull market, but no one ever went bust from that; there are far worse fates.

  To avoid losses, we need to understand and avoid the pitfalls that create them. In this chapter I bring together some of the key issues discussed in earlier chapters, in the hope that highlighting them under one umbrella will help investors become more alert for trouble spots. The starting point consists of realizing that many kinds of pitfalls exist and learning what they look like.

  I think of the sources of error as being primarily analytical/intellectual or psychological/emotional. The former are straightforward: we collect too little information or incorrect information. Or perhaps we apply the wrong analytical processes, make errors in our computations or omit ones we should have performed. There are far too many errors of this sort for me to enumerate, and anyway, this book is more about philosophy and mind-set than it is about analytical processes.