May 10, 2011
Howard Marks is widely regarded for his thought-provoking essays on the discipline and process of value investing. He is the chairman and co-founder of California-based Oaktree Capital, and he delivered the keynote address at the Value Investing Congress in Pasadena last week.
His latest book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, is available from the link above.
Below are his remarks. Excerpts from the Q&A appear here.
I titled this presentation “The Human Side of Investing, or the Difference between Theory and Practice.” That subtitle is very simple: It is from a great quote from Yogi Berra, who said, "In theory, there is no difference between theory and practice, but in practice there is." That is extremely true about investing.
Everybody knows about financial analysis, and financial analysis of course is the core of value investing. Most of us have also had exposure to investment theory as taught on college campuses nowadays, and it is distinct from financial analysis.
It is very important to realize that there is another side. The textbooks and professors will tell you about the dependable workings of the market, which I will try to debunk a little bit. They will describe a simple roadmap to investment success, as if, as you do this and this and this, you will make money. But that assumes that there is an underlying process that can be counted on to work. That is not true. The thing that keeps it from working unfailingly is what I call the human side of investing, and that is really why I wrote the book.
The difference between theory and practice
For example, investment theory tells us that markets are efficient, objective, and clinical, and for that reason they price assets correctly. The truth is markets are made up of people, with their emotions, insecurities, their tendency to go to extremes, and their other foibles. Thus, they often make mistakes and swing to erroneous extremes.
In theory, people are risk averse, and for that reason riskier assets must provide higher returns than safe assets in order to attract capital. I believe that this is one of the greatest underlying errors that markets make. Riskier assets must appear to offer higher returns on invested capital, but they need not provide it. In fact, riskier assets usually appear to promise higher returns, but that doesn't mean they are coming. If riskier assets could always be expected to provide higher returns, then they wouldn't be riskier. It is really as simple as that.
In theory, there is an appropriate risk premium that is incorporated into prospective returns on riskier assets. In practice, sometimes the risk premium is inadequate, and sometimes it is excessive, and it is incumbent upon us to know the difference.
We are all familiar with the graphic that shows an increasing return on assets as risk increases, and theory says this is how markets are. But I have seen markets that look the opposite, as in the middle of 2007, for example. The returns were low all across the spectrum, and in particular the slope of the risk-return line was low, meaning that the incremental return on assets as risk increased was very modest.
We have also seen times when the risk premium was excessive. The fourth quarter of 2008, after the Lehman bankruptcy, was a good example – returns were very high, and, in particular, the incremental return for taking incremental risk was particularly high. If you think about it, it is the slope of this line that tells you whether it is wise to step out and pursue higher returns, or whether it is wise to stay back and be safe with lower risk assets.
In theory, since markets price assets fairly, if you buy at market prices you should be able to expect a fair risk-adjusted return. That's what theory says. But, in practice, buying without discernment at the market price will give you returns that are all over the lot. If prices aren't always fair – and we are sure they are not – then buying at the market price cannot be counted on to give us a fair risk-adjusted return.
In theory, people want more of something at lower prices, and less of it at higher ones. We all learned in microeconomics that this is what the demand curve looks like. When price is high, the quantity demanded is low. But when price is low the quantity demanded is high. It makes only sense; that is why people buy more of things when they go on sale.
But, in truth, investors warm to investments when prices rise and shun them when they fall. We all know investors – certainly not ourselves – who buy at 80 and when it hits 100 they say, “I've got this right.” When it hits 120 they say, “This is working I'm going to double up.” If instead they buy at 80 and it goes to 60, they say, “I better wait a moment.” At 40, they say, “I should lighten up,” and at 20 they say, “I should sell the rest before it goes to zero.”
For many investors, the demand curve looks inverted. They buy at higher prices and sell at lower prices, and this is an example of what we must do the exact opposite. A lot of what I say about the human side of investing concerns something I call the pendulum. The pendulum of investment psychology is constantly fluctuating between optimism and pessimism, between greed and fear, between credulousness and skepticism, between risk tolerance and risk aversion. It will always swing, and it is the presence of optimism, greed, credulousness, and risk tolerance that makes markets most dangerous.
In theory, that pendulum should be at what we call the happy medium. If you ask a statistician, “On average, where is the pendulum?” he will tell you on average it is in the middle. But think about that pendulum. How much of its time does it spend in the middle at the happy medium? Very little at all; rather there are frequent excesses, and these constitute the errors of herding behavior.
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