April 15, 2013
The Most Important
Thing
Uncommon Sense for the Thoughtful Investor
Howard Marks
©2011 Columbia University Press
Adapted by permission of Columbia University Press
ISBN: 978-0-231-15368-3
Key Concepts
• To achieve superior investing results, individuals • Following the herd and swinging with the
must practice the difficult task of forming correct market’s pendulum yields average performance
views about value that go against popular opinion. over the long run and can cause total ruin at the
extremes.
• Successful investing requires an accurate estimate
of intrinsic value—buying an asset at a price • The key during a financial crisis is to be positioned
below its value is the most dependable route to to buy instead of sell. Patient opportunism coupled
profit. with contrarianism and a strong balance sheet can
deliver amazing profits from meltdowns.
• Since no one knows for sure what will happen in
the future, investing always involves some risk. • Never underestimate the role randomness (or
Dealing with risk is really the essential element of luck) plays in investing.
investing because an investor has to intelligently • The critical element in defensive value investing
bear risk to make a profit. is having a margin of safety or margin for error.
• Everything is cyclical, and cycles eventually
prevail with nothing moving in one direction Introduction
forever.
In The Most Important Thing, Howard Marks
• The biggest mistakes in investing are not informa- details his own investment philosophy based on
tional or analytical mistakes, but emotional and his experience as founder and chairman of Oaktree
psychological ones. Capital Management and a successful money
Business Book Summaries® April 15, 2013 • Copyright © 2013 EBSCO Publishing Inc. • All Rights Reserved
The Most Important Thing Howard Marks
manager. His overall philosophy is drawn from a can lead to big mistakes, but blind adherence limits
series of memos written to clients of Oaktree. Marks opportunities.
makes it clear that successful investing requires
Linking Value and Price
thoughtful consideration of many separate aspects
The old adage, “Buy low, sell high” refers to the act
about an investment. The book is not a step-by-step
of buying an asset at less than its intrinsic value,
investment guide but instead offers insights into
then selling it at a price higher than what was paid.
return, risk, and process to help investors make better
Being able to ascertain an asset’s true value is the
decisions and avoid common pitfalls. His insights are
indispensible starting point for investing.
meant to be thought-provoking, controversial, and
somewhat contrarian to established wisdom. Most investing is based on two types of approaches:
fundamental and technical. Marks himself is skeptical
Second Level Thinking and Market
about technical investment theory because it relies on
Efficiency
a stock’s past price action, and he cites the random
Marks makes it clear that few people can be superior
walk hypothesis that states past price behavior cannot
investors who beat market averages. Successful
predict future price. Fundamental analysis seeks to
investing requires more perceptive thinking,
gauge the underlying intrinsic value of a company
superior insight, a sense of value, and psychological
and its stock in order to buy or sell when the stock
awareness—what Marks refers to as second level
price diverges from the intrinsic value. Investing
thinking. First level thinking is simple and superficial,
based on fundamentals such as earnings, cash flow,
such as “the outlook is for slow growth, so dump
dividends, hard assets, debt, and enterprise value
stocks.” Second level thinking is deeper, more
can also be bracketed into two kinds: value or growth
complex, and convoluted—“the outlook stinks,
investing. Value investing looks at the fundamentals
everyone is selling, so buy.”
to find stocks that seem inexpensive compared to a
Outperforming the market means outthinking the company’s intrinsic worth. Growth investing seeks
average investor. Conventional wisdom says that to identify companies that are growing fast with
the market is efficient and that asset prices reflect potential for future appreciation. For value investors,
the consensus view based on available information. price is everything—a stock is only attractive if it is
This is why pundits claim it is impossible to beat the priced right.
market, and that low-priced index funds are the best
investment choice. Marks has reservations about the
efficient market theory because of the way it links Further Information
return and risk. The difference in returns between
one investor and another can often be attributed to Information about the author and subject:
risk. Risky investments may deliver better returns, www.oaktreecapital.com
but the investor assumes more risk, and there are no Information about this book and other business titles:
guarantees. cup.columbia.edu
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level thinker looks at the information and asks, “Who
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doesn’t know that?” Second-level thinkers look for Fraud-Proof Your Investments
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arise. If prices can be wrong, then it is possible to find
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Business Book Summaries® April 15, 2013 • Copyright © 2013 EBSCO Publishing Inc. • All Rights Reserved Page 2
The Most Important Thing Howard Marks
A stock’s price can be influenced by two factors investing, ordinary people tend to believe the biggest
other than fundamentals: market psychology and risk is losing capital.
technicals, such as margin calls or large inflows of
Investment risk can unfold in many ways.
mutual fund money. Psychology will often dictate
Sometimes the best investors have long periods of
whether a stock is well liked or not, and can drive
underperformance because they are willing to deviate
market “bubbles” where momentum takes over.
from the benchmark indexes. Understanding risk
Basing investing decisions on fundamentals and solid
means knowing more things can happen than actually
value is the most dependable approach, but it helps
do happen, and entails looking into the future for a
to have the technicals and psychology aligned behind
broad range of outcomes. There is a big difference
the stock as well.
between probability and outcome—probable things
Profitable investing occurs when: often do not happen at all and improbable events can
happen any time.
• An asset’s intrinsic value rises
• An investor uses leverage to Good times teach only bad lessons: that investing is easy, that
magnify a gain
you know its secrets, and that you don’t need to worry about
• An asset is sold for more than risk. The most valuable lessons are learned in tough times.
it is worth
• An asset is purchased for less than it is worth Return has to be calibrated based on the risk
undertaken, yet risk cannot really be measured
Of all those possibilities, the last is the most reliable. because it exists only in the future. The decision to
Buying an asset below its intrinsic worth is not undertake risk is usually based on normal recurring
infallible, but it is the best chance for success. patterns, but sometimes the improbable happens.
Dealing with Risk People expect the future to be like the past and
underestimate the potential for change. Risk can show
Investing is placing a bet on the future, and since
up in clusters—if mortgages default an average of two
no one knows what will happen in the future, there
percent per year, an unusual spate can occur (as did
is always risk involved. Risk is the most important
a few years ago) to throw off the averages. Investors
element to understand, recognize, and control. Stock
often view risk as the best route to better returns, but
prices are presumed to render prospective returns
it does not always work out that way.
proportional to the risk assumed. Riskier investments,
however, cannot be counted on to deliver superior Recognizing and Controlling Risk
returns. Although many pundits look at volatility Great investing means generating returns and
in price fluctuations as the biggest risk to stock controlling risk, and recognizing risk is a prerequisite
to controlling it. When prices are high, so is risk.
Awareness of the relationship between price and
value is an essential component of dealing with risk.
About the Author A prime contributor to risk is when popular opinion
believes risk is low. This drives up prices, as in 2005-
Howard Marks is chairman and cofounder of
2007, and creates bubbles that eventually burst. When
Oaktree Capital Management, a Los Angeles-
everything looks rosy, the danger of risk is higher—
based investment firm with $80 billion under
the attitude that “risk is gone” is actually a major risk
management. He holds a bachelor’s degree in
driver. What is needed most during these times is
finance from the Wharton School and an MBA
skepticism and worry.
in accounting and marketing from the Univer-
sity of Chicago. Risk can be very hard to recognize. When the market
is doing well, with bullish momentum and prices up,
then prospective returns get lower. When confidence
Business Book Summaries® April 15, 2013 • Copyright © 2013 EBSCO Publishing Inc. • All Rights Reserved Page 3
The Most Important Thing Howard Marks
increases, so does risk. When fear and dread take willing to spend more for an asset. Often, the worst
over, risk goes down with prices. Marks refers to this loans and investments are made during the best times.
relationship as the perversity of risk. Investment risk Then the cycle reverses—losses shrink the capital
exists most where it is least perceived and vice versa. available, and the economy shrivels. Ignoring cycles
When popular opinion believes something is risky, and making inferences based on current trends is one
then the price goes down, creating a risk premium of the riskiest things an investor can do. Investors
with optimism driven out of the price. If opinion says should never assume that because a company or stock
there is no risk, the price is higher, and so too is the is doing well that it will forever.
risk.
Investors should think of the
If prices in efficient markets reflect the consensus, then sharing stock market like a pendulum.
The mid-point in the arc is the
the consensus view will likely earn just an average return. median, but the pendulum rarely
To beat the market, you must hold an idiosyncratic, or non- stays there. It is usually swinging
consensus, view. toward one side or the other.
Whenever the pendulum reaches
Smart investors are distinguished as much by either extreme, it inevitably swings back toward the
the ability to control risk as by achieving good other. The pendulum moves in reaction to greed and
returns. Some great investors do not produce fear, and attitudes toward risk are a common driver
astonishing returns, but instead only take risks that behind market fluctuations. Improper risk aversion
are commensurate with returns. These investors contributes to bubbles and crashes. When greed
may produce modest returns with very little risk or prevails, risk is ignored. Conversely, fear generates
high returns with only moderate risk. Risk is covert risk aversion.
and not observable, just like a building may not be
Boiled down to basics, there are two market risks: the
obviously unable to withstand an earthquake until
risk of losing money and the risk of losing opportunity.
the earthquake strikes; it is the potential for loss when
The crash of 2007-2008 was preceded by a dismissal of
things go wrong.
risk. The ensuing crash raised fear levels so that many
The job of an investor is to intelligently bear risk. investors sold at a loss and positioned themselves too
Investors need to differentiate between risk control defensively to partake in the ensuing market rebound.
and risk avoidance. Risk control is the best way to
The pendulum action in the stock market is
loss avoidance; whereas risk avoidance likely leads
dependable, and when the pendulum swings, most
to return avoidance. Long-term investing success
people do the wrong thing—they rush to buy when
relies on risk control far more than aggressive action.
prices are high, then sell into panic. Marks says the
Skilled investors can take advantage of inefficient
stock market’s 2009 dip and subsequent recovery
markets to achieve the same results as the benchmark
presented the greatest buying opportunity in his
indexes while assuming less risk. Risk reduction is a
career.
fundamental for successful investing, and the superior
investor undertakes less risk to produce comparable Market Psychology and Contrarianism
returns to other portfolios. Market inefficiencies and mistakes people make
are the best opportunities for profit—as long as the
Mind the Cycles
investor is on the right side of the mistake. Many
It is essential to remember that everything runs in
investors reach the same conclusion about an asset
cycles, and that some of the best opportunities for
based on data analysis, yet they behave differently
gain or loss come when people forget this. Everything
due to psychology.
waxes and wanes. This is especially true of economies
and companies because they involve humans, who There are seven emotions that cause investors to make
are emotional and inconsistent. When people feel mistakes:
good, they spend more money and save less, and are 1. Greed causes people to chase gains.
Business Book Summaries® April 15, 2013 • Copyright © 2013 EBSCO Publishing Inc. • All Rights Reserved Page 4
The Most Important Thing Howard Marks
2. Fear prevents constructive action. price appreciation, and when the crowd changes
its collective mind, the price falls. Marks believes
3. Suspension of disbelief can defy logic.
the best investments are contrarian, challenging,
4. Conforming to the herd prevents second level and uncomfortable to do; that is why the concept of
thinking. intrinsic value is so important.
5. Envy makes investors seek to have what others Finding Bargains and Spotting
have. Opportunity
6. Ego demands gratification. Building a portfolio of investments requires a list
of realistic assets, estimates of intrinsic value, price
7. Capitulation leads to surrender.
comparisons with value, understanding of risk, and
All bubbles begin with a grain of truth, then greed, how an asset will affect the entire portfolio. Investing
suspension of disbelief, and ignoring value and risk by definition requires a selection process that must
leads to disaster. Bubbles can arise on their own, but be rigorous, disciplined, and comparative. Failure
all crashes are preceded by a bubble. It seems smart to distinguish between good assets and good buys
to buy at the top with the herd, and it is hard to resist leads to poor return. The best choices have high value
selling when the market tanks. relative to price, and the potential return is high
relative to risk.
The market can go to irrational extremes based on
human psychology. Investors can resist its influence To find such assets, investors should look for those
by: that are misunderstood, controversial, unappreciated,
or selling off. Bargains provide value at unreasonably
• Establishing a sense of true intrinsic value.
low prices and low ratios of risk. They are not
• Acting when price diverges from value. supposed to exist in efficient markets, but the forces
• Recognizing the insidious effects of psychology that are supposed to eliminate bargains do not always
on the market. operate.
• Remembering that when The potential upside for being right about growth is more
things seem too good to be
dramatic, and the upside potential for being right about value
true, they usually are.
is more consistent. Value is my approach… consistency trumps
• Being willing to appear wrong
drama.
when market valuation seems
incorrect. Marks believes the bubble of 2005-2007 and subsequent
Most investors are trend followers while superior crash of 2007-2008 provided a once in a lifetime
investors do the opposite of the crowd. Markets opportunity to profit in the stock market. Those who
can swing dramatically, and market extremes sold at elevated levels in 2007, then came back to
represent inflection points. Accepting the concept of scoop up bargains in 2009 could have made fortunes.
contrarianism seems simple, but putting in into action He urges investors to let investments come their way
is difficult because one never knows how far the rather than chase after them. This approach means
pendulum will swing. Markets can be over- or under- rather than making a list of what to buy, investors
valued for years and stay that way. should instead select from what sellers are motivated
to sell. It is a matter of patient opportunism. Investors
Practicing contrarianism is not simply taking the must resist the pressure to buy because there is no
opposite view of the herd; instead, it is looking for penalty for missing an opportunity, only for making a
and identifying why the consensus is wrong. A losing investment.
paradox of investing is that often things that seem
obvious turn out to not be true at all. When everyone Obviously, no one wants to miss a profitable
likes something, there is probably little room left for opportunity, especially professional money managers
Business Book Summaries® April 15, 2013 • Copyright © 2013 EBSCO Publishing Inc. • All Rights Reserved Page 5
The Most Important Thing Howard Marks
who must demonstrate performance, but missing luck. The only way to assess a money manager’s
an opportunity has far less negative significance success is through a track record that consistently
than investing in a loser. However, no one can create beats the market while minimizing risks.
opportunities if they do not exist in the market at the
Play Defensively to Avoid Mistakes
time.
Warren Buffet, chairman and CEO of Berkshire
The best buying opportunities arise from forced Hathaway, is believed by many to be the world’s best
selling. Forced sellers have no choice and typically investor. Buffet always champions investing in assets
have to sell regardless of price, which may fall far that provide a “margin of safety” or “margin for
below intrinsic value. The key to surviving a market error.” And that goes right back to the value and price
crisis is to be insulated from forces that mandate ratio. If an asset is selling at $90 but due diligence
selling, and being positioned to be a buyer. Patient shows the asset to be worth $100, that underpriced
opportunism backed by contrarianism and a good asset is showing a margin of safety.
balance sheet can reap great rewards during market
Defensive investing seeks to screen out losers from
meltdowns.
a portfolio. Marks continually emphasizes how
important it is to avoid mistakes
Most people seem to think outstanding performance to date that result in losses. The way to
presages outstanding future performance. Actually, it is more exclude losers in a portfolio is to
likely that performance to date has borrowed from the future “invest scared” and seek out only
and thus presages subpar performance from here on out. low prices, be skeptical about
ongoing prosperity, and know that
Knowledge and Luck the future is uncertain. A defensive investor will suffer
When it comes to investing, investors must be aware less pain when things go horribly wrong, and can
of what they do not know. The best approach is often yield moderate returns with occasional home runs.
a small picture one—to know what is knowable about When it comes to trying to maximize returns through
individual companies and their securities. This is the aggressive investing or avoiding losses through a
fundamental data related to intrinsic value (earnings, defensive portfolio, Marks is a firm adherent to the
debt, revenues, gross margin, etc.). Investors can latter approach. Gain can be had in the stock market
then get a sense of the current cycle and the way the from doing a few things right and minimizing wrong
pendulum is swinging. Every trend stops sooner or decisions. Avoiding losses can be done more often
later, and nothing moves in one direction forever. and dependably than pursuing maximum gains.
Investors must stay alert to the extremes, adjust Investing errors tend to be either intellectual/analytical
behaviors, and resist following the herd. When others or emotional/psychological. A typical intellectual
are selling into panic, smart investors buy; and when error is failure of imagination, or the inability to
the crowd is recklessly confident, they should sell. grasp the full range of possibilities and outcomes.
Environments such as that found in 2007 with free Lack of recognition about asset correlation—how
access to capital, loose terms, and excessive leverage the action of one asset influences that of another—is
are danger signs that point to future market crashes. another common mistake. Psychological/emotional
When greed crowds out fear, the market is dangerous forces drive bubbles and crashes, and second level
and risky. Market extremes do not occur often, so they thinkers actively seek to take advantage of these rare
are not a frequent source of error, but can generate occurrences.
large losses when they do happen. Some pitfalls in stock market investing are:
Like all other aspects of life, luck plays a role in stock • Disregard for risk
market investing. Sometimes someone makes a risky
bet on an improbable future which proves true. But • Inadequate due diligence about value
that is not a sign of genius or expertise, it is random • Hidden portfolio correlation risk
Business Book Summaries® April 15, 2013 • Copyright © 2013 EBSCO Publishing Inc. • All Rights Reserved Page 6
The Most Important Thing Howard Marks
• Psychological and emotional factors that influence Contents
decision making Introduction
Selling at the bottom always incurs permanent losses. The Most Important Thing Is…
Marks advises to think about what today’s mistakes
might be—not buying, not buying enough, too much Chapter 1: Second-Level Thinking
risk/return avoidance, buying too aggressively, or Chapter 2: Understanding Market Efficiency (and Its
taking on too much risk in pursuit of gains. Limitations)
Achieving Alpha Chapter 3: Value
Two commonly used terms and concepts used in
Chapter 4: The Relationship Between Price and Value
investment theory are:
Chapter 5: Understanding Risk
1. Alpha: The ability to generate better performance
than the market. Chapter 6: Recognizing Risk
2. Beta: A portfolio’s correlation to market Chapter 7: Controlling Risk
performance. Chapter 8: Being Attentive to Cycles
A beta of one means that a portfolio typically moves Chapter 9: Awareness of the Pendulum
up or down in proportion to the market. The measure
of true investing skill (alpha) translates into losses Chapter 10: Combating Negative Influences
that are smaller in proportion to market losses while Chapter 11: Contrarianism
capturing average or better gains when the market
rises. Chapter 12: Finding Bargains
g g g g
Chapter 13: Patient Opportunism
Chapter 14: Knowing What You Don’t Know
Features of the Book Chapter 15: Having a Sense for Where We Stand
Estimated Reading Time: 6–7 hours, 180 pages Chapter 16: Appreciating the Role of Luck
The Most Important Thing by Howard Marks is Chapter 17: Investing Defensively
a must-read for anyone interested in stock market
investing, from experienced money managers to Chapter 18: Avoiding Pitfalls
individual investors. It is written in a conversational Chapter 19: Adding Value
style with little jargon, and the few technical terms
used are explained. Marks does assume that the reader Chapter 20: Pulling It All Together
has some fundamental knowledge about investing, so
this is a not an elementary guide for those new to the
stock market. There are interesting quotes from well-
known investors in addition to references to other
books related to investing and economics. Charts
and graphs illustrate stock market and investing
principles. The final chapter offers short summaries of
the vast wisdom Marks has gleaned from his 40-year
career, and provides a quick and contemplative way
to revisit the most important points about investing.
Business Book Summaries® April 15, 2013 • Copyright © 2013 EBSCO Publishing Inc. • All Rights Reserved Page 7
The Most Important Thing Howard Marks
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