In The Most Important Thing, Howard Marks the chairman and founder of Oaktree Capital Management shares the most important things for a successful investor.
If you read his memos, you’d know that he explains complex things in an understandable manner. Similarly, the ideas discussed in this book are very readable. There are no numbers and graphs. That being said, concepts are rehashed in different ways across chapters, so it might be repetitive if you are already a seasoned investor.
Nonetheless, I strongly recommend this book for budding investors as it helps to build foundational understanding which is essential for further skills. You will understand the value investing philosophy, contrarianism, and how to overcome negative psychological biases when it comes to investing.
Here are my 4 key takeaways from The Most Important Thing:
1) Most things come in cycles
Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero.
In investing, as in life, there are very few sure things. Howard Marks believes in 2 concepts:
- Rule number one: Most things will prove to be cyclical
- Some of the greatest opportunities for gain and loss come when other people forget rule number one.
Analysts extrapolate trends and make predictions about the markets.
However, ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.
Investing is a popularity contest. The most dangerous thing is to buy a stock at the peak of its popularity.
At its peak, all favourable facts and opinions are already priced in. No new buyers are left to emerge.
Thus, the safest and potentially the most profitable thing to do is to buy something when no one likes it. Given that the fundamentals are strong, its popularity and thus its price can only go one way: up.
Be attentive to cycles.
2) Second-level Thinking
First-level thinking is simplistic and superficial. It’s about simple formulas and easy answers.
Almost everyone can make the same judgment (i.e. “Coronavirus is bad for the markets, the outlook for the companies are unfavourable, so stocks will go down”).
Second-order thinking is more deliberate and higher-order. It is thinking in terms of interactions and systems. In reality, things together in a complex system and not in silos.
To achieve extraordinary returns, you have to see things that other people can’t see and rise above first-level thinking.
The upshot is simple: to achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be right. That’s not easy… The good news is that the prevalence of first-level thinkers increases the returns available to second level thinkers. To consistently achieve superior investment returns, you must be one of them.
This relates to the concept of being contrarian.
Contrarianism is not just simply doing the opposite of the crowd.
It’s about knowing why the crowd is wrong.
Detect when price diverges significantly from intrinsic value. Recognise the errors others have made and profit from them.
Here are some guiding questions:
- Out of the range of future outcomes, which outcome do I think will occur? What’s the probability I’m right?
- What does the consensus think?
- How does my expectation differ from the consensus?
- How does the current price for the asset compare with the consensus view of the future, and with mine?
- Is the consensus psychology that’s incorporated in the price too bullish or bearish?
- What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
“Conventional wisdom is one of the greatest oxymoron.”
3) Understanding risk
I’m sure you have came across the phrase “Higher risk, higher returns.”
But in value investing, high returns and low risk can be achieved simultaneously.
Here, understanding the difference between risk and volatility is crucial.
Some people confuse the concept of a stock being “risky” because of price fluctuations. But this is not true.
Risk =/= volatility.
Risk is the uncertainty of outcome and the probability of loss. Whereas volatility is about price fluctuations.
Stock prices fluctuate all the time due to market sentiments and investor confidence. Volatility creates opportunities for you to buy and sell.
A company that generates higher returns does not mean that it has higher risk. The fundamentals of the company and buying it a discount to intrinsic value.
Likewise, if you flip it around, the absence of loss does not equate to a safe portfolio.
Risk may be present even though loss does not occur when the market is stable or rising.
As Buffett mentioned, “Only when the tide goes out do you discover who’s been swimming naked.”
Avoid the Big Losers
It’s not about finding the best returns because that is hard to predict.
Much easier to avoid risk (i.e. the big losers) because it’s more predictable.
4) Appreciate the Role of Luck
When it comes to judging whether you made the right investment decision, focus on your reasoning analysis.
The correctness of a decision cannot be judged based on the outcome (e.g. profits, percentage growth).
To judge if your decision was right, you have to look at how you formulate your investment thesis and the reasons you choose to buy the stock.
A good decision is one that is optimal at the time it is made, when the future is by definition unknown. [It is] one that a logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known.
As Nassim Taleb says, you can be a “lucky idiot”.
Every once in a while, someone makes a risky bet on an improbable or certain outcome and ends up looking like a genius. But we should recognise that it happened because of boldness, not skill… One good coup can be enough to build a reputation, but clearly a coup can arise out of randomness alone. Few of these ‘geniuses’ are right more than once or twice in a row [Taleb refers to them as ‘lucky idiots’].
Summary
In investing and in life, you can’t do the same things as others and expect to outperform.
The most dependable way to outperform the market is to buy a stock for less than its intrinsic value.
Recognise that luck plays a role and it’s your second-order thinking and analysis, not so much the outcome, that proves whether your decision was right.
These ideas are simple but difficult to practice in real life. If investing were easy, so many would not fail.
Additional Resources:
Oaktree Capital Memos
Read the book
Youtube Video
