What’s the cornerstone of successful investing? How can you exploit market cycles for your own gain? Is there a way to mitigate investment risks?
To the outsider, the world of investing can seem daunting to enter. But in The Most Important Thing, Howard Marks proclaims that anyone can learn the basics needed to invest successfully, as long as they implement the lessons he’s learned from a lifetime of investing.
Read below for an overview of the book The Most Important Thing.
The Most Important Thing by Howard Marks
In his 2011 book The Most Important Thing, Howard Marks outlines the key tenets of his approach to investing. He argues that the best approach to investing in securities—any financial asset with monetary value, like stocks and bonds—is value investing, which involves determining securities’ intrinsic value and purchasing below it. To practice it successfully, you must learn the nature of market cycles to find opportunities for purchasing mispriced securities, while also learning how to mitigate the risk entailed by investing. Moreover, Marks contends that you must avoid the pitfalls that ensnare many investors, like greed and a herd mentality.
As the co-founder and co-chairman of Oaktree Capital Management, an investment firm that manages $179 billion in assets, Marks brings years of real-life investing experience to The Most Important Thing. Additionally, key insights from Marks’s widely renowned investing memos—which Warren Buffett has praised—often form the foundation of his arguments throughout the book.
The Fundamentals of Value Investing
According to Marks, value investing—the practice of purchasing securities below their intrinsic value—is the cornerstone of successful investing. In this section, we’ll detail value investing in greater depth, outlining Marks’s reasons for recommending it over growth investing and offering concrete strategies for finding underpriced securities.
Value Investing vs. Growth Investing
As Marks relates, value investing and growth investing represent different investing approaches based on securities’ fundamentals—that is, information that reflects the financial health of a security, such as revenue, cash flow, and profit margins. He argues that value investing is superior to growth investing because it yields more consistent and dependable returns.
To understand growth and value investing, however, we first need to understand the notion of intrinsic value. At its core, intrinsic value refers to the fair value of a security, assuming all relevant information was factored into its price. For example, if extreme pessimism led investors to excessively sell Amazon stock at the beginning of 2023, then Amazon’s share price of $85.46 might have been lower than its intrinsic value per share.
Marks notes that value and growth investors agree that over the long term, securities’ prices roughly match their intrinsic value. However, this agreement yields different conclusions. On one hand, value investors seek out underpriced securities—those whose price is below their intrinsic value—reasoning that, as the market corrects this disparity, these securities will increase in price. On the other hand, growth investors seek securities whose intrinsic value has high growth potential—even if these securities aren’t currently underpriced—reasoning that, as their intrinsic value increases over time, so too will their trading price.
But Marks contends that it’s much more difficult to assess long-term potential than present value. Moreover, he writes that unless you’re superior to the market at identifying potential, it’s likely that this potential is already factored into the security’s price. For example, Tesla’s stock price at the beginning of 2020—$28.30 per share—likely reflected not only Tesla’s business fundamentals, but also its potential for explosive growth. In turn, he concludes that value investing generates more consistent—and less speculative—returns than growth investing, making it preferable for investors.
How to Find Underpriced Securities
Having shown it’s possible for the market to underprice securities, Marks then offers concrete advice for finding underpriced securities. He argues that to find underpriced securities, look for those that investors have significantly misjudged. Marks reasons that if investors have accurately assessed a security, then it’s likely trading around its intrinsic value. But, if investors have inaccurately assessed a security (in this case, by underestimating it), the security’s market price will be lower than its intrinsic value.
To put this argument into practice, Marks offers several signs to look for that might indicate an underpriced security:
- Its price has rapidly decreased, leading average investors to stay away from it.
- It has some clear shortcoming that makes it less attractive to investors.
- It’s widely regarded as a poor investment, meaning that it’s not drawing much capital.
If any of these conditions are satisfied, it’s possible that other investors (and thus the market) will undervalue the security, leaving you poised to take advantage of their mistake.
The Nature of Investing Cycles
According to Marks, one reason why securities’ prices can diverge from their intrinsic value is that investing markets undergo cycles—pricing fluctuations often driven by factors beyond the business fundamentals that determine intrinsic value. In this section, we’ll examine Marks’s account of the origins of investing cycles, their implications, and how investors can exploit them for their own gain.
Investing Cycles and Their Origins
Marks explains that securities’ markets are cyclical—they oscillate between highs and lows in the wake of psychological changes among investors. In light of these cycles, Marks argues that investors should avoid extrapolating from recent trends because these trends are often upended when cycles shift.
To understand Marks’s argument, it helps to first understand the origins of investing cycles. According to Marks, cycles occur as investors alternate between excessive risk tolerance and excessive risk aversion. Excessive risk tolerance generates cyclical highs as investors become too optimistic and overpay for securities under the assumption that prices can only increase. Excessive risk aversion yields cyclical lows as investors grow pessimistic and invest too sparingly.
Because investors’ attitudes toward risk fluctuate rather than remain static, Marks concludes that it’s a mistake to assume the future will look like the recent past when investing. For example, novice investors might invest in the stock market after it grew exponentially in the last year, assuming it will do so again in the next year, but according to Marks, this is a mistake: As investors become more or less risk averse, securities’ markets that can experience wide swings on a yearly basis.
Exploit Investing Cycles to Increase Returns
Though cycles can ensnare novice investors looking to turn a quick profit, they can also provide lucrative opportunities for savvy investors. To that end, Marks argues that investors can generate outsized returns by taking contrarian positions at cyclical extremes because securities are significantly mispriced at these extremes.
At a broad level, Marks notes that at any given point in a cycle, most investors’ views about the market will reflect that phase of the cycle. For example, in a bull market, most investors will be optimistic, leading them to frequently buy assets and drive up prices—otherwise, there wouldn’t be a bull market to begin with. However, Marks points out that acting in line with the consensus can only lead to market-average returns, by definition. After all, if you invest the same as the majority of investors, you won’t be able to outperform them.
Consequently, Marks concludes that acting contrary to the majority of investors is necessary for above-market returns. Specifically, he contends that contrarian investing is most powerful when cycles reach extremes—for instance, purchasing securities at the peak of a bear market (when prices are about to rise) or selling securities at the peak of a bull market ( when securities are about to drop). Nonetheless, he admits that contrarian investing isn’t always advisable—after all, for large portions of investing cycles, there aren’t widespread discrepancies between price and value. So, Marks recommends that investors base contrarian decisions on rigorous analyses of intrinsic value to maximize their chance of finding market errors.
How to Mitigate Investing Risk
Even rigorous analysis of securities’ value, however, can’t entirely shield investors from risk. On the contrary, Marks contends that risk is an unavoidable aspect of investing. In this section, we’ll outline Marks’s conception of risk, his warning signs of a risky market, and his recommendations for controlling risk by practicing defensive investing.
Marks’s View of Risk vs. the Academic View of Risk
According to Marks, any approach to investing requires an understanding of risk. He defines risk as the probability that you’ll lose money because that is investors’ greatest concern.
To see the novelty of Marks’s definition, it helps to understand the main alternative that he rejects—namely, the standard academic view that equates risk with portfolio volatility, the extent to which the portfolio experiences swings in value. As Marks relates, this view is based on the assumption that more volatile investments are less reliable, increasing risk for investors.
In Marks’s evaluation, this academic view misses the mark. Specifically, he suggests that investors aren’t concerned with portfolio fluctuations per se because fluctuations alone don’t always cost investors money in the long run. On the contrary, a security’s price might fluctuate wildly, but as long as its price follows an upward trend over time, it can yield large returns. For this reason, Marks clarifies that the real risk of investing is the possibility of permanent loss—based on his own investing experience, he argues that this prospect most worries investors.
The upshot is that risk can’t be objectively measured, and only investors with careful qualitative analysis can discern the risk associated with a given security. In particular, Marks argues that investors must ascertain how stable a security’s intrinsic value is, along with the nature of the connection between this value and the security’s market price. After all, these are the two factors that determine the likelihood of loss: If a security’s value dips, or the market fails to accurately reflect this value, investors will lose money.
(Shortform note: Although Marks claims we can’t objectively measure risk, many professional economists attempt to do just that. For example, some economists measure risk via the Sortino ratio, which measures how a given security’s downside volatility compares to the average downside volatility of all comparable securities. However, formulas like these are based on the assumption that volatility equates to risk, a premise that, as we’ve seen, Marks rejects.)
Control Risk Through Defensive Investing
Though he discourages high-risk investments, Marks recognizes that eliminating risk altogether—for example, by purchasing 10-year government bonds that return around 4% annually—will yield unsatisfying returns. He argues that, to balance this inverse relationship between risk and return, you should practice defensive investing, which uses a margin of safety to reap reliable returns while minimizing risk.
As Marks relates, the margin of safety refers to the difference between a security’s intrinsic value and its market price when purchased. For example, imagine that you purchased Tesla stock at $118.47 at the beginning of 2023, and its intrinsic value was $150 per share. Then, your margin of safety would be about $32 per share.
According to Marks, investing based on the margin of safety has two key benefits. First, as we discussed earlier, securities purchased below their intrinsic value are likely to increase in price because market price typically reflects intrinsic value over the long term. Second, the margin of safety protects investors from loss if the intrinsic value of a security decreases. Returning to the previous example, even if Tesla’s intrinsic value dropped to $120 per share, it’s unlikely that you’d lose money since you purchased at $118.47 per share.
Psychological and Intellectual Pitfalls to Avoid
While investing grounded in the margin of safety sounds straightforward in theory, investing is more complicated in practice. As Marks points out, that’s because investors often succumb to emotional or intellectual pitfalls when investing. In this section, we’ll consider the primary investing mistakes that you must avoid to maximize your success.
Common Psychological Pitfalls
While Marks admits that investing markets might be perfectly efficient if investors were fully objective and rational, he contends that the opposite is true: Psychological influences affect investors’ decisions, cutting into potential profits. And though Marks lists an array of such influences, we’ll focus on the effects of three key ones: greed, fear, and the desire to conform.
Pitfall #1: Greed
First, Marks argues that greed leads investors to make suboptimal decisions as it causes them to abandon caution. He points out that when investors are overcome by their desire to earn money, they cast aside risk aversion in hopes of earning an outsized profit. For instance, a greedy investor might spend an exorbitant amount of money investing in an unproven cryptocurrency, leaving them exposed to massive losses if the investment fails. For this reason, Marks maintains that greed is one of the most potent forces working against investors.
Pitfall #2: Fear
On the other end of the spectrum, Marks holds that fear causes investors to leave profits on the table because scared investors are unwilling to take even well-informed risks. According to Marks, fear paralyzes the would-be investor. For example, a fearful investor might see an opportunity to purchase a security for far below its intrinsic value, only to be frozen by the possibility that they’ll ultimately lose money. In this way, fear can hinder investors from maximizing their potential returns.
Pitfall #3: Conformity
Both greed and fear, however, can result from a greater problem afflicting investors: the desire to conform to other investors’ behavior. Marks argues that conformity often leads investors to act irrationally when the consensus view is misguided, as it often is. Specifically, he contends that pressure to conform causes investors to forsake their own due diligence when assessing securities and incur excessive risk, as they reason that the consensus view can’t be mistaken. In turn, this behavior leads investors to purchase securities that they would never have purchased otherwise.
Common Intellectual Pitfalls
While emotions like greed and fear can spell disaster for investors, Marks argues that intellectual mistakes can also lead to subpar investments. Specifically, he contends that investors who are too credulous and those who fail to consider rare outcomes are susceptible to large losses.
Pitfall #1: Excessive Credulity
First, Marks maintains that gullible investors often accept delusions that require them to ignore past investing wisdom. For example, you might recognize that investing markets have experienced cycles historically, meaning that peak bull markets often lead to bear markets with their associated price drops. Even knowing this, the credulous investor could become convinced that these past norms no longer apply, causing them to continue purchasing securities under the delusion that prices can only rise. In this manner, credulity can result in excessive risk that leaves investors exposed to potential losses.
Pitfall #2: Lack of Imagination
In a similar vein, Marks argues that investors who lack imagination will fail to plan for rare contingencies, leaving them vulnerable to loss when those contingencies occur. He maintains that such investors plan for the future by extrapolating from the recent past, assuming the future will reflect the past. However, this lack of imagination means they won’t account for instances when the future does diverge from the past—for example, when the dot-com bubble burst in 2000, as technology companies’ stock prices plummeted despite investors assuming that these prices could only increase. Consequently, investors without imagination pay the price when the future doesn’t meet their expectations.
How to Avoid These Pitfalls
Marks contends that there’s no foolproof strategy for avoiding these pitfalls. However, he does offer one main suggestion to investors: Remain keenly aware of market conditions, especially the supply-and-demand relationship for securities, because such awareness will help you realize when securities are mispriced.
For example, to avoid succumbing to greed, you might recognize that capital is flowing too freely into fledgling, high-risk securities in the technology sector as investors hope to find a diamond in the rough. In such a situation, cognizance of this market trend would help you realize that these securities are likely overpriced. Similarly, to avoid excessive credulity, you might recognize an inordinate demand for (say) real estate because investors think real estate values can only increase. By remaining aware of this, you’ll be poised to avoid the trap of thinking that past trends about the housing market are no longer relevant.
