The Most Important Thing: Uncommon Sense for the Thoughtful Investor

Marks, Howard


  • Dedication
  • About the Annotators
  • Foreword by Bruce C. Greenwald
  • Introduction
  • 1 The Most Important Thing is … Second Level Thinking
  • 2 … Understanding Market Efficiency (and Its Limitations)
  • 3 … Value
  • 4 … The Relationship Between Price and Value
  • 5 … Understanding Risk
  • 6 … Recognizing Risk
  • 7 … Controlling Risk
  • 8 … Being Attentive to Cycles
  • 9 … Awareness of the Pendulum
  • 10 … Combating Negative Influences
  • 11 … Contrarianism
  • 12 … Finding Bargains
  • 13 … Patient Opportunism
  • 14 … Knowing What you Don’t Know
  • 15 … Having a Sense for Where We Stand
  • 16 … Appreciating the Role of Luck
  • 17 … Investing Defensively
  • 18 … Avoiding pitfalls
  • 19 … Adding Value
  • 20 … Reasonable Expectations
  • 21 … Pulling It All Together
  • About the Author

About the Annotators

  • Christopher C. Davis – a portfolio manager of the Davis Large Cap Value portfolios; M.A. from the University of St. Andrews in Scotland.
  • Joel Greenblatt – Columbia Business School; a managing partner of Gotham Capital
    The Big Secret for the Small Investor (Crown Business, 2011),
    The Little Book That Beats the Market (John Wiley & Sons, 2005)
    You Can Be A Stock Market Genius (Simon & Schuster, 1997).
  • Bruce C. Greenwald – Columbia Business School;
    A Radically Simplified Approach to Business Strategy (with Judd Kahn, Putnam Penguin, 2005),
    Value Investing: From Graham to Buffett and Beyond (with Judd Kahn, et al, Wiley, 2001).
  • Paul Johnson – Columbia University; founded Nicusa Capital
  • Seth A. Klarman – the president of The Baupost Group;
    Margin of Safety (HarperCollins, 1991),

    lead editor for Security Analysis: Sixth Edition (McGraw-Hill, 2008)

    • innate: inborn; natural: superior investement ability seems to be innate.
      • resonates: 共鸣: these four thinkers discuss how Marks’s philosophy sesonates with, refines, or occasionally deffers from their own.
      • surrogate: 代理:I like to think of The Most Important Thing Illuminated as a surrogate book group with five of the best investment thinkers alive.


  • creed, a system of religious belief; a faith: I consider it my creed, and in course of my investing career it has served like a religion.
  • ensnare, catch in or as in a trap: avoid the pitfalls that ensnare so many.
  • disservice, a harmful action: Those who try to simplify investing do their audience a great disservice.

Heaven for me would be seven little words: “I never thought of it that way.”

  • tick, √: When potential clients want to understand what makes Oaktree tick, their number one question is usually some variation on “What have been the keys to your success?”

A philosophy has to be the sum of many ideas accumulated over a long period of time from a variety of sources. One cannot develop an effective philosophy without having been exposed to life’s lessons.

It’s not the specific facts or processes I learned that mattered most, but being exposed to the two main schools of investment thought and having to ponder how to reconcile and synthesize them into my own approach.

Importantly, a philosophy like mine comes from going through life with your eyes open. You must be aware of what’s taking place in the world and of what results those events lead to. Only in this way can you put the lessons to work when similar circumstances materialize again.

Seth klarman: Keeping your eyes open also increases the probability that you will be prepared for something that has never before occurred. … Alertness can help to identify and possibly avoid growing risks before it is too late. Marks makes this point in chapter 5.

I like to say, “Experience is what you got when you didn’t get what you wanted.”

Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times. In that sense, I’ve been “fortunate” to have lived through some doozies: the Arab oil embargo, stagflation, Nifty Fifty stock collapse and “death of equities” of the 1970s; Black Monday in 1987, when the Dow Jones Industrial Index lost 22.6 percent of its value in one day; the 1994 spike in interest rates that put rate-sensitive debt instruments into freefall; the emerging market crisis, Russian default and meltdown of Long-Term Capital Management in 1998; the bursting of the tech-stock bubble in 2000–2001; the accounting scandals of 2001–2002; and the worldwide financial crisis of 2007–2008.

If you read widely, you can learn from people whose ideas merit publishing. Some of the most important for me were Charley Ellis’s great article “The Loser’s Game” (The Financial Analysts Journal, July-August 1975), A Short History of Financial Euphoria, by John Kenneth Galbraith (New York: Viking, 1990) and Nassim Nicholas Taleb’s Fooled by Randomness (New York: Texere, 2001).

Finally, I’ve been extremely fortunate to learn directly from some outstanding thinkers: John Kenneth Galbraith on human foibles; Warren Buffett on patience and contrarianism; Charlie Munger on the importance of reasonable expectations; Bruce Newberg on “probability and outcome”; Michael Milken on conscious risk bearing; and Ric Kayne on setting “traps” ( underrated investment opportunities where you can make a lot but can’t lose a lot). I’ve also benefited from my association with Peter Bernstein, Seth Klarman, Jack Bogle, Jacob Rothschild, Jeremy Grantham, Joel Greenblatt, Tony Pace, Orin Kramer, Jim Grant and Doug Kass.

I’m convinced that no idea can be any better than the action taken on it, and that’s especially true in the world of investing.

3 … Value

For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point.

Warren Buffett says that the best investment course would teach just two things well: How to value an investment and how to think about market price movements.

Herb Stein’s wry observation that “if something cannot go on forever, it will stop.”
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“good” businesses that are available at an attractive price.
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consistency trumps drama.
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It’s hard to consistently do the right thing as an investor. But it’s impossible to consistently do the right thing at the right time. The most we value investors can hope for is to be right about an asset’s value and buy when it’s available for less.
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“buying dollars for fifty cents.”
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“Being too far ahead of your time is indistinguishable from being wrong.”
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many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated, and they like it less as the price falls, when they begin to doubt their decision to buy. This makes it very difficult to hold, and to buy more at lower prices
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If you liked it at 60, you should like it more at 50 . . . and much more at 40 and 30.
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“buying good things,”
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“buying things well.”
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The key is who likes the investment now and who doesn’t.
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The biggest losers—be they Nifty-Fifty stocks in 1969, Internet stocks in 1999, or mortgage vehicles in 2006—had
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“priced for perfection,” “on the pedestal of popularity,” and “nothing can go wrong.”
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John Maynard Keynes pointed out, “The market can remain irrational longer than you can remain solvent.” Howard Marks:
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Risk means more things can happen than will happen. –Elroy Dimson
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Warren Buffett and Julian Robertson in 1999.
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The most dangerous investment conditions generally stem from psychology that’s too positive.
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They believe high return and low risk can be achieved simultaneously by buying things for less than they’re worth. In the same way, overpaying implies both low return and high risk.
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the greatest risk in these low-luster bargains lies in the possibility of underperforming in heated bull markets. That’s something the risk-conscious value investor is willing to live with.
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Elroy Dimson that led off this chapter: “Risk means more things can happen than will happen.”
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“There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” That’s one of the most important things you can know about investment risk.
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Joel Greenblatt: When thinking about a portfolio of investments, one thing to keep in mind is that the correlation of these improbable occurrences can affect many of your investments at the same time.
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risk cannot be measured. Certainly it cannot be gauged on the basis of what “everybody” says at a moment in time.
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Risk can be judged only by sophisticated, experienced second-level thinkers.
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Maybe “worst-case” means “the worst we’ve seen in the past.” But that doesn’t mean things can’t be worse in the future. In 2007, many people’s worst-case assumptions were exceeded.
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because the system is now more stable, we’ll make it less stable through more leverage, more risk taking.
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–Myron Scholes
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it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions. –Andrew Crockett
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Great investing requires both generating returns and controlling risk.
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Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.
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“Risk is my friend. The more risk I take, the greater my return will be.
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high risks demand risk premiums But psychology affects
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There are few things as risky as the widespread belief that there’s no risk,
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The riskiest things : A few times in my career, I’ve seen the rise of a belief that risk has been banished, cycles won’t occur any longer, or the laws of economics have been suspended.
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fairy tales
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Pension & Investments
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the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions. Regardless of what’s designed into market structures, risk will be low only if investors behave prudently.
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The risk-is-gone myth is one of the most dangerous sources of risk, and a major contributor to any bubble.
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“Too Much Trust, Too Little Worry.”
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carefree, unworried investors are their own worst enemy.
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Worry and its relatives, distrust, skepticism and risk aversion, are essential ingredients in a safe financial system.
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Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion.
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“It’s only when the tide goes out that you find out who’s been swimming naked.” Pollyannas take note: the tide cannot come in forever. –IT’S ALL GOOD, July 16, 2007
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“perversity of risk.”
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I’m firmly convinced that investment risk resides most where it is least perceived, and vice versa:
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When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.
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Chinese market. Bank. Coal. Shipping. 4-8-2013
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it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.
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High absolute return is much more recognizable and titillating than superior risk-adjusted performance. That’s why it’s high-returning investors who get their pictures in the papers.
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the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard. That’s especially true in good times.
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Warren Buffett, Peter Lynch, Bill Miller and Julian Robertson.
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Bottom line: risk control is invisible in good times but still essential, since good times can so easily turn into bad times.
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no mean feat.
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Controlling the risk in your portfolio is a very important and worthwhile pursuit. The fruits, however, come only in the form of losses that don’t happen. Such what-if calculations are difficult in placid times.
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it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.
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I’ve said for years that risky assets can make for good investments if they’re cheap enough. The essential element is knowing when that’s the case.
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the best test for which is a record of repeated success over a long period of time.
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risk bearing is neither wise nor unwise per se.
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Extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it’ll never happen—that assumptions regarding risk were too conservative. Thus, it becomes tempting to relax rules and increase leverage. And often this is done just before the risk finally rears its head.
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But if in the future we always said, “We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,” we’d be frozen in inaction.
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I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007–2008 prove there’s no easy answer.
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Oaktree doesn’t run from risk. We welcome it at the right time, in the right instances, and at the right price.
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Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.
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everything is cyclical.
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Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero.
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we never know what lies ahead, but we can prepare for the possibilities and reduce their sting.
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Rule number one: most things will prove to be cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.
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when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.
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real estate in 1989–1992; emerging markets in 1994–1998; Long-Term Capital Management in 1998; the movie exhibition industry in 1999–2000; venture capital funds and telecommunications companies in 2000–2001. In each case, lenders and investors provided too much cheap money and the result was overexpansion and dramatic losses.
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wax and wane
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Investors will overvalue companies when they’re doing well and undervalue them when things get difficult.
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“virtuous cycles” or “vicious cycles”—self-feeding
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dangerous premise that “this time it’s different.”
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Oh Yeah? ,
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“this time it’s different.”
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They cite the changes in geopolitics, institutions, technology or behavior that have rendered the “old rules” obsolete. They make investment decisions that extrapolate the recent trend. And then it
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turns out that the old rules do still apply, and the cycle resumes. In the end, trees don’t grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical. –YOU CAN’T PREDICT. YOU CAN PREPARE, November 20, 2001
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Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do. People often act as if companies that are doing well will do well forever,
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and investments that are outperforming will
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outperform forever,
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The second investor memo I ever wrote, back in 1991, was devoted almost entirely to a subject that I have come to think about more and more over the years: the pendulum-like oscillation of investor attitudes and behavior.
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The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.
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investor psychology seems to spend much more time at the extremes than it does at a “happy medium.”
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credulousness versus skepticism; and risk tolerance versus risk aversion.
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When greed is prevalent, it means investors feel a high level of comfort with risk and the idea of bearing it in the interest of profit. Conversely, widespread fear indicates a high level of aversion to risk. The academics consider investors’ attitude toward risk a constant, but certainly it fluctuates greatly.
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The pendulum swing regarding attitudes toward risk is one of the most powerful of all.
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the risk of losing money and the risk of missing opportunity.
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It’s possible to largely eliminate either one, but not both.
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the three stages of a bull market.
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The first, when a few forward-looking people begin to believe things will get better The second, when most investors realize improvement is actually
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taking place The third, when everyone concludes things will get better forever
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Stocks are cheapest when everything looks grim.
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These few words capture the challenges of successful investing. It is hard for the average investor to commit capital to a new
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investment when the outlook is gloomy. Yet it is precisely in these moments that potential returns are at their highest.
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the three stages of a bear market: The first, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy The second, when most investors recognize things are deteriorating The third, when everyone’s convinced things can only get worse
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rephrase its key observations:
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never know:
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Why do mistakes occur? Because investing is an action undertaken by human beings, most of whom are at the mercy of their psyches and emotions.
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People who don’t care about money generally don’t go into investing.)
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fear like greed—connotes excess.
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“Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.”
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the process of investing requires a strong dose of disbelief. . . . Inadequate skepticism contributes to investment losses.
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“Extreme brevity of the financial memory,” to use John Kenneth Galbraith’s wonderful phrase,
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“Rising prices are a narcotic that affects the reasoning power up and down the line.”
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How Markets Fail , John Cassidy
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ego .
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the road to investment success is usually marked by humility, not ego.
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capitulation ,
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But then psychology and crowd influences move in. Much of the time, assets are overpriced and appreciating further, or underpriced and still cheapening. Eventually these trends have a corrosive effect on investors’ psyches, conviction and resolve. The stocks you rejected are making money for others, the ones you chose to buy are lower every day, and concepts you dismissed as unsafe or unwise—hot new issues, high-priced
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tech stocks without earnings, highly levered mortgage derivatives—are described daily as delivering for others. As an overpriced stock goes even higher or an underpriced stock continues to cheapen, it should get easier to do the right thing: sell the former and buy the latter. But it doesn’t. The tendency toward self-doubt combines with news of other people’s successes to form a powerful force that makes investors do the wrong thing, and it gains additional strength as these trends go on longer. It’s one more influence that must be fought.
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The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing—these factors are near universal. Thus they have a profound collective impact on most investors and most markets. This is especially true at the market extremes. The result is mistakes—frequent, widespread, recurring, expensive mistakes.
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Standard & Poor’s 500 stock index showed a gain every year from 1991 through 1999 inclusive, and its return averaged 20.8 percent per year.
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Believe me, it’s hard to resist buying at the top (and harder still to sell)
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“It’s not supposed to be easy.”
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Here are the ones that work for Oaktree:
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a strongly held sense of intrinsic value,
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To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.
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trend followers .
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buy when they hate ’em, and sell when they love ’em.
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“Once-in-a-lifetime” market extremes seem to occur once every decade or so—not often enough for an investor to build a career around capitalizing on them.
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the six-foot-tall man who drowned crossing the stream that was five feet deep on average.
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In the long run, the market gets it right. But you have to survive over the short run, to get to the long run.
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Contrarianism isn’t an approach that will make you money all of the time. Much of the time there aren’t great market excesses to bet against.
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just because no one else will jump in front of a Mack truck barreling down the highway, doesn’t mean that you should!
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based on reason and analysis. You must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong.
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Only then will you be able to hold firmly to your views and perhaps buy more as your positions take on the appearance of mistakes and as losses accrue rather than gains.
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David Swensen
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Fear of looking wrong : The very words used here—uninstitutional, idiosyncratic, imprudent, lonely, and uncomfortable—provide an idea of how challenging it is to maintain nonconsensus positions. But doing so is an absolute must if superior performance is to be achieved.
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investment skepticism is associated with rejecting investment
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bull market
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and Ponzi schemes.
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During the crisis, lots of bad things seemed possible, but that didn’t mean they were going to happen. In times of crisis, people fail to make that distinction….
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you’ll be a conformist, not a maverick; a follower, not a contrarian.
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Certain common threads run through the best investments I’ve witnessed. They’re usually contrarian, challenging and uncomfortable—although
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The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain.
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Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.
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Even sophisticated investors may not say, “I’ll buy anything if it’s cheap enough.” More often they create a list of investment candidates meeting their minimum criteria, and from those they choose the best bargains.
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Sid Cottle,
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“investment is the discipline of relative selection.”
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potential bargains usually display some objective defect.
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bargains are often created when investors either fail to consider an asset fairly, or fail to look beneath the surface to understand it thoroughly, or fail to overcome some non-value-based tradition, bias or stricture.
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ignored or scorned.
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Seth Klarman: Generally, the greater the
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better the bargain.
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highly unpopular.
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no one can think of a reason to own it.
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Fairly priced assets are never our objective, since it’s reasonable to conclude they’ll deliver just fair returns for the risk involved. And, of course, overpriced assets don’t do us any good.
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A good place to start is among things that are: little known and not fully understood; fundamentally questionable on the surface; controversial, unseemly or scary; deemed inappropriate for “respectable” portfolios; unappreciated, unpopular and unloved; trailing a record of poor returns; and recently the subject of disinvestment, not accumulation.
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the necessary condition for the existence of bargains is that perception has to be considerably worse than reality.
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That means the best opportunities are usually found among things most others won’t do. After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.
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“Real men don’t buy converts, so chickens like me can buy cheap.”
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if nobody owns something, demand for it (and thus the price) can only go up and (b) by going from taboo to even just tolerated, it can perform quite well.
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given the way investors behave, whatever asset is considered the worst at a given point in time has a good likelihood of being the cheapest.
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You’ll do better if you wait for investments to come to you rather than go chasing after them. You
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“we don’t look for our investments; they find us.” We try to sit on our hands. We don’t go out with a “buy list”; rather, we wait for the phone to ring.
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mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Thus we must recognize, accept, cope and respond.
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In Berkshire Hathaway’s 1997 Annual Report, Buffett talked about Ted Williams—the “Splendid Splinter”—one of the greatest hitters in history. A factor that contributed to his success was his intensive study of his own game. By breaking down the strike zone into 77 baseball-sized “cells” and charting his results at the plate, he learned that his batting average was much better when he went after only pitches in his “sweet spot.” Of course, even with that knowledge, he couldn’t wait all day for the perfect pitch; if he let three strikes go by without swinging, he’d be called out.
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investors needn’t feel pressured to act. They can pass up lots of opportunities until they see one that’s terrific.
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“Investing is the greatest business in the world because you never have to swing. You stand at the plate; the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity. All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.” –WHAT’S YOUR GAME PLAN?
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Set the bar too high and you might remain out of the market for a very long time. Set it too low and you will be fully invested almost immediately; it will be as though you had no standards at all. Experience and versatile thinking are the keys to such calibration.
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The key is managing clients effectively—which almost always means lowering client expectations.
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missing a profitable opportunity is of less significance than investing in a loser.
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investors succumbed to the siren song of leverage. They borrowed cheap short-term funds—the shorter
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the cheaper
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You simply cannot create investment opportunities when they’re not there. The dumbest thing you can do is to insist on perpetuating high returns—and give back your profits in the process. If it’s not there, hoping won’t make it so. When prices are high, it’s inescapable that prospective returns are low (and risks are high).
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Peter Bernstein
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“The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”
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You want to take risk when others are fleeing from it, not
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when they’re competing with you to do so.
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Being early provided a good reminder about the pain involved in being too far ahead of your time. Having said that, it was much better to get off too soon in May 2005 than to stay on past May 2007.
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The beauty of forced sellers is that they have no choice.
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Those last three words—regardless of price are the most beautiful in the world if you’re on the other side of the transaction.
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This was a time for the patient opportunist to step forward. It was primarily those who had been cognizant of the risks in 2006 and 2007 and kept their powder dry—waiting for opportunity—who were able to do so. The key during a crisis is to be (a) insulated from the forces that require selling and (b) positioned to be a buyer instead.
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We have two classes of forecasters: Those who don’t know—and those who don’t know they don’t know. –John Kenneth Galbraith It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on. –Amos Tversky There are two kinds of people who lose money: those who know
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nothing and those who know everything. –Henry Kaufman
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Its adherents generally believe you can’t know the future; you don’t have to know the future; and the proper goal is to do the best possible job of
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investing in the absence of that knowledge.
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Understanding uncertainty :
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Maybe Mark Twain put it best: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
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Acknowledging the boundaries of what you can know—and working within those limits rather than venturing beyond—can give you a great advantage.
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We may never know where we’re going, but we’d better have a good idea where we are.
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a great deal of data, and all my experience, tell me that the only thing we can predict about cycles is their inevitability.
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The second possibility is to accept that the future isn’t knowable, throw up our hands, and simply ignore cycles. Instead of trying to predict them, we could try to make good investments and hold them throughout.
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First, we must be alert to what’s going on.
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“take the market’s temperature.”
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So look around, and ask yourself: Are investors optimistic or pessimistic ? Do the media talking heads say the markets should be piled into or avoided? Are novel investment schemes readily accepted or dismissed out of hand? Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls? Has the credit cycle rendered capital readily available or impossible to obtain? Are price/earnings ratios high or low in the context of history, and are yield spreads tight or generous?
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The seven scariest words in the world for the thoughtful investor—too much money chasing too few deals provided an unusually apt description of market conditions.
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One trend investors might have observed during this dangerous period, had they been alert, was the movement along the spectrum that runs from skepticism to credulousness in regard to what I described earlier as the silver bullet or can’t-lose investment. Thoughtful investors might have noticed that the appetite for silver bullets was running high, meaning greed had won out over fear and signifying a nonskeptical—and thus risky—market.
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8 to 11 percent
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Too few people recognized that achieving rock-steady returns in that range would be a phenomenal accomplishment—perhaps too good to be true. (N.B.: that’s exactly what Bernard Madoff purported to be earning.)
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there’s simply no magic in investing.
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Economy: Vibrant Sluggish Outlook: Positive Negative Lenders: Eager Reticent Capital markets: Loose Tight Capital: Plentiful Scarce Terms: Easy Restrictive Interest rates: Low High Spreads: Narrow Wide Investors: Optimistic Pessimistic Sanguine Distressed Eager to buy Uninterested in buying Asset owners: Happy to hold Rushing for the exits Sellers: Few Many Markets: Crowded Starved for attention Funds: Hard to gain entry Open to anyone New ones daily Only the best can raise money
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General Partners hold all the cards Limited Partners have bargaining power Recent performance: Strong Weak Asset prices: High Low Prospective returns: Low High Risk: High Low Popular qualities: Aggressiveness Broad reach Caution and discipline Selectivity
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The investment world is not an orderly and logical place where the future can be predicted and specific actions always produce specific results.
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The truth is, much in investing is ruled by luck. Some may prefer to call it chance or randomness , and those words do sound more sophisticated than luck . But it comes down to the same thing: a great
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deal of the success of everything we do as investors will be heavily influenced by the roll of the dice.
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Paul Johnson:
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For me the theme of this chapter is: Learn to be honest with yourself about your successes and failures. Learn to recognize the role luck has played in all outcomes. Learn to decide which outcomes came about because of skill and which because of luck. Until one learns to identify the true source of success, one will be fooled by randomness.
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Warren Buffett’s appendix to the fourth revised edition of The Intelligent Investor describes a contest in which each of the 225 million Americans starts with $1 and flips a coin once a day. The people who get it right on day one collect a dollar from those who were wrong and go on to flip again on day two, and so forth. Ten days later, 220,000 people have called it right ten times in a row and won $1,000. “They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.” After another ten days, we’re down to 215 survivors who’ve been right 20 times in a row and have each won $1 million.
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They write books titled like How I Turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning and sell tickets to seminars. Sound familiar?
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when things go right, luck looks like skill.
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Taleb’s important points.
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Since the investors of the “I know” school, described in chapter 14, feel it’s possible to know the future, they decide what it will look like, build portfolios designed to maximize returns under that one scenario, and largely disregard the other possibilities. The suboptimizers of the “I don’t know” school, on the other hand, put their emphasis on constructing portfolios that will do well in the scenarios they consider likely and not too poorly in the rest. Investors who belong to the “I know” school predict how the dice will come up, attribute their successes to their astute sense of the future, and blame bad luck when things don’t go their way. When they’re right, the
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that school of thought.
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There are old investors, and there are bold investors, but there are no old bold investors.
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what ails you.
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Charles Ellis, titled “The Loser’s Game,”
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The Financial Analysts Journal in 1975.
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His views on market efficiency and the high cost of trading led him to conclude that the pursuit of winners in the mainstream stock markets is unlikely to pay off for the investor. Instead, you should try to avoid hitting losers. I found this view of investing absolutely compelling.
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The bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match. Thus, defense—significant emphasis on keeping things from going wrong—is an important part of every great investor’s game.
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competitive some succeed and some fail, and the distinction is clear.
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quantitative you can see the results in black and white.
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meritocracy in the long term, the better returns go to the superior investors.
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team oriented an effective group can accomplish more than one person.
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satisfying and enjoyable but much more so when you win.
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There can be a premium on aggressiveness, which doesn’t serve well in the long run. Unlucky bounces can be frustrating. Short-term success can lead to widespread recognition without enough
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attention being paid to the likely durability and consistency of the record. Overall, I think investing and sports are quite similar, and so are the decisions they call for.
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I think investing is more like the “football” that’s played outside the United States—soccer. In soccer, the same eleven players are on the field for essentially the whole game. There isn’t an offensive squad and a defensive squad. The same people have to play both ways . . . have to be able to deal with all eventualities. Collectively, those eleven players must have the potential to score goals and stop the opposition from scoring more.
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Because coaches know they won’t have many opportunities to switch between offensive and defensive personnel during the game, they have to come up with a winning lineup and pretty much stick with it.
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And, by the way, there’s no right choice between offense and defense. Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for.
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There are two principal elements in investment defense. The first is the exclusion of losers from portfolios. This is best accomplished by conducting extensive due diligence,
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The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes.
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Concentration (the opposite of diversification) and leverage are two examples of offense.
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Use enough of them, however, and they can jeopardize your investment survival
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things go awry.
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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?
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“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
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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.
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“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.
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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.
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Low price is the ultimate source of margin for error.
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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 .
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too many people think about how good they are and how much they’ll make if they swing for
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the fences and connect.
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they don’t have enough winners, but because they have too many losers.
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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.
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“if we avoid the losers, the winners will take care of themselves.”
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home runs.
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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
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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.
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Operating a high-risk portfolio is like performing on the high wire without a net. The payoff for success maybe high and bring oohs and aahs. But those slipups will kill you.
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The cautious seldom err or write great poetry.
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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.
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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.
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In investing, almost everything is a two-edged sword.
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The only exception is genuine personal skill.
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if it’ll help if it works, that means it’ll hurt if it doesn’t.
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Invest scared!
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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
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An investor needs do very few things right as long as he avoids big mistakes. –Warren Buffett
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“Failure of imagination”—the inability to understand in advance the full breadth of the range of outcomes—is
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Bruce Newberg’s
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Things that aren’t supposed to happen do happen.
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double sixes should come up once in every 36 rolls of the dice. But they can come up five times in a row—and never again in the next 175 rolls—and in the long run have occurred as often as they’re supposed to.
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Relying to excess on the fact that something “should happen” can kill you when it doesn’t. Even if you properly understand the underlying probability distribution, you can’t count on things happening as they’re supposed to. And the success of your investment actions shouldn’t be highly dependent on normal outcomes prevailing; instead, you must allow for outliers.
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Most of the meltdowns in the recent credit crisis took place because something didn’t go as it was supposed to.
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The financial crisis occurred largely because never-before-seen events collided with risky, levered structures that weren’t engineered to withstand them.
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As an aside, it’s worth noting that the assumption that something can’t happen has the potential to make it happen, since people who believe it can’t happen will engage in risky behavior and thus alter the environment.
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mortgage payments were limited to 25 percent of monthly income by tradition;
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In many ways, psychological forces are some of the most interesting sources of investment terror. They can greatly influence security prices. When they cause some investors to take an extreme view that isn’t balanced out by others, these forces can make prices go way too high or way too low. This is the origin of bubbles and crashes.
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The best defense against loss is thorough, insightful analysis and insistence on what Warren Buffett calls “margin for error.”
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as Buffett has said, “Beware of geeks with models.”
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It makes little sense to use leverage to try to turn inadequate returns into adequate returns.
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Pitfalls were everywhere: investors were unworried, even ebullient in the years leading up. People believed that risk had been banished, and thus they need worry only about missing opportunity and failing to keep up, not about losing money.
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The riskiest things : A high level of belief and a corresponding low level of skepticism always play a large part in the ascent of prices that, afterward, everyone sees as having risen too high.
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Surviving the declines and buying at the resultant lows was a great formula for success—especially relative success—but first it required the avoidance of pitfalls.
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to think about what “today’s mistake” might be and try to avoid it.
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Active investors who don’t possess the superior insight described in chapter 1 are no better than passive investors,
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their risk-adjusted performance shouldn’t be expected to be better than the passive portfolio.
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This one has a ton, if you can live with the volatility:
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A single year says almost nothing about skill, especially when the
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results are in line with what would be expected on the basis of the investor’s style.
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The real question is how they do in the long run and in climates for which their style is ill suited.
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With Skill Gains a lot when the market goes up, but doesn’t lose to the same degree when the market goes down Doesn’t lose much when the market goes down, but captures a fair bit of the gain when the market goes up
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Without skill, aggressive investors move a lot in both directions, and defensive investors move little in either direction.
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Everything in investing is a two-edged sword and operates symmetrically, with the exception of superior skill.
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Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek. Superior skill is the prerequisite for it.
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in the good years average is good enough.
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it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious.
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Oaktree actually returns capital whenever the opportunity set shrinks.
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Asymmetry—better performance on the upside than on the downside relative to what your style alone would produce—should be every investor’s goal.
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no investment activity is likely to be successful unless the return goal is (a) explicit and (b) reasonable in the absolute and relative to the risk entailed.
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Every investment effort should begin with a statement of what you’re trying to accomplish. The key questions are what your return goal is, how much risk you can tolerate, and how much liquidity you’re likely to require in the interim.
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Most of the time—although not necessarily at any particular point in time (and not necessarily today)—it’s reasonable to aspire to returns in single digits or perhaps low double digits. High teens are something very special, and anything more should be viewed as the province of experienced pros (and only the best of those). The same is true of particularly consistent results.
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The returns Madoff claimed weren’t outrageously high: just 10 percent a year or so.
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What was extraordinary was the way he reported them year in and year out. Even a down month was a rarity. Yet few of his investors asked how these returns were achieved or wondered whether they were actually possible.
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For most of the twentieth century, common stocks averaged a 10 percent return. But they did it with substantial volatility and a fair number of down years.
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He reported those returns for almost twenty years, regardless of the investment environment
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It’s essential to understand that “cheap” is far from synonymous with “not going to fall further.”
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fact alone often causes others to hide behind the excuse that “it’s not our job to catch falling knives.” After all, it’s when knives are falling that the greatest bargains are available.
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Perfection in investing is generally unobtainable; the best we can hope for is to make a lot of good investments and exclude most of the bad ones.
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Rather, if we think something is cheap, we buy. If it gets cheaper, we buy more. And if we commit all our capital, we assume we’ll be able to raise more.
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if we find something attractive, we never say, “It’s cheap today, but we think it’ll be cheaper in six months, so we’ll wait.” It’s just not realistic to expect to be able to buy at the bottom.
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To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them—ideally, all three.
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The relationship between price and value holds the ultimate key to investment success. Buying below value is the most dependable route to profit. Paying above value rarely works out as well.
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perception understates reality.
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goal is to find good buys, not good assets.
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“What the wise man does in the beginning, the fool does in the end.”
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tread more carefully.
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“Being too far ahead of your time is indistinguishable from being wrong.”
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Most investors think diversification consists of holding many different things; few understand that diversification is effective only if portfolio holdings can be counted on to respond differently to a given development in the environment.
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“If we avoid the losers, the winners will take care of themselves,”
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“Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average.”
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The more micro your focus, the greater the likelihood you can learn things others don’t.
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it’s worth noting that there’s usually someone who gets it exactly right . . . but it’s rarely the same person twice. The most successful investors get things “about right” most of the time, and that’s much better than the rest.
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For us to conclude that investors truly add value, we have to see how they perform in environments to which their style isn’t particularly well suited.
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