PDF Summary:The Most Important Thing, by Howard Marks

To the outsider, the world of investing can seem daunting to enter—if not outright impossible. But according to investment professional Howard Marks, anyone can learn the basics needed to invest successfully.

In his 2011 book The Most Important Thing, Marks outlines the key tenets of his approach to investing. He argues that the best approach for investors 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.

In this guide, we’ll outline the fundamentals of value investing, discuss market cycles and how they’re useful to the value investor, and analyze the common mistakes that often leave investors exposed to unnecessary risk. Throughout the guide, we’ll also examine recommendations from other investors that supplement—and occasionally challenge—Marks’s investing wisdom.

(continued)...

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.

(Shortform note: Taking contrarian positions is a key component of what’s more generally known as contrarian investing, in which investors buck widespread investing trends that they believe are ill-founded. Such renowned investors as Benjamin Graham, author of The Intelligent Investor, and Warren Buffett, the “Oracle of Omaha,” are considered contrarians.)

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.

(Shortform note: Harmful institutional incentives to avoid looking foolish might offer one reason why so many investors follow suit with cyclical trends. In The Signal and the Noise, Nate Silver argues that professional forecasters’ reputations can suffer if they incorrectly oppose the consensus view, inclining them to make conservative predictions that, when incorrect, are less embarrassing. So, in a similar vein, investors might hesitate to buck mainstream trends because the embarrassment of mistakenly betting against these trends is much greater than the embarrassment of mistakenly betting in line with these trends.)

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.

(Shortform note: Although Marks advocates for contrarianism on the grounds that it can yield above-market returns, it’s worth emphasizing that “market-average” returns would actually place you better than the majority of investors. In fact, while the S&P 500 averaged annual returns of about 6% between 2000 and 2020, the average equity fund investor averaged only 4.25%. Experts point out that this disparity occurs because investors often buy when the market is high and sell when it’s low, leading to below-market returns. Additionally, John C. Bogle argues in The Little Book of Common Sense Investing that many investors earn below-market returns because they invest in mutual funds with high turnover rates, which charge fees that cut into their profits.)

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.

(Shortform note: In The Warren Buffett Way, Robert G. Hagstrom clarifies that academics equate risk with volatility because of their reliance on the efficient market hypothesis (EMH). Hagstrom points out that, because the EMH assumes all investing success boils down to luck, proponents of the EMH believe that investors with volatile portfolios are simply more likely to lose money. So, it stands to reason that Marks’s disagreement with academics’ view on risk stems from his disagreement with their view on market efficiency.)

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.

(Shortform note: Some experts disagree with Marks’s claim that investors aren’t concerned with portfolio fluctuations. According to experts in behavioral finance, many investors suffer from myopic loss aversion—the combination of loss aversion and a tendency to chronically check their portfolios.). As Daniel Kahneman relates in Thinking, Fast and Slow, loss aversion refers to our tendency to weigh losses more heavily than equivalent gains. Thus, when investors suffer loss aversion and chronically check their portfolios, losses from short-term fluctuations can prove psychologically painful.)

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.)

Indications of a Risky Market

Although Marks maintains that risk is immeasurable, he admits that there are warning signs that often indicate the presence of high risk. Specifically, he argues that widespread high prices are indicative of high risk because high prices are a proxy for excessive optimism and risk tolerance.

Marks reasons that when prices soar, it’s more likely that stocks’ prices fail to include a risk premium, which is the difference between a stock’s expected return and the risk-free rate of return (typically the guaranteed return from government bonds). For example, if Apple stock started to soar, it’s likely that the expected return would drop closer to the risk-free return of a one-year Treasury bond (4.72% at the beginning of 2023) because prices can’t rise indefinitely. According to Marks, this means investors are no longer compensated for the risk they incur when purchasing stocks instead of risk-free bonds, leaving them exposed to more risk without the prospect of a proportionately higher return.

(Shortform note: Because risk premiums depend on the risk-free rate of return, it follows that the same expected return from a security can yield a different risk premium depending on the risk-free rate at the time. For example, imagine that you could expect a 10% return on Amazon stock at the beginning and end of 2022. At the beginning of 2022, when the one-year Treasury bond offered a 0.4% return, your risk premium would be 9.6% (10% minus 0.4%). But at the end of 2022, when the one-year Treasury bond offered a 4.7% return, your risk premium would be much smaller at 5.3% (10% minus 4.7%).)

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.

(Shortform note: Graham, who first introduced the concept of margin of safety in The Intelligent Investor, argued that one crucial way to increase your margin of safety is through diversification (purchasing more securities of different types). He reasoned that, even with a margin of safety, investing in only one security leaves you exposed to loss if that security drops significantly. For instance, even with a $32 per share margin of safety when purchasing Tesla stock, a large drop in Tesla’s intrinsic value could leave you exposed to a loss if that was your only investment. By contrast, with a diverse portfolio, you’ll still be able to earn a profit even if some of your securities drop in value.)

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.

(Shortform note: Although investing with a margin of safety has these benefits, experts point out that it also suffers drawbacks. In particular, establishing a margin of safety requires accurately determining a security’s intrinsic value—a practice which, experts warn, rarely lends itself to a precise answer. For example, Buffett’s method of calculating intrinsic value requires estimating a company’s future net income, which is an inherently subjective estimate. For this reason, investors can easily think they’ve established a margin of safety because of a faulty intrinsic value calculation, leaving them overconfident.)

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.

(Shortform note: Although it’s impossible to precisely determine greed’s influence, CNN business experts have developed a fear and greed index that estimates which emotions are driving the market. This index relies on seven metrics—including market momentum, market volatility, and the demand for junk bonds—to assess whether the market is greedy, fearful, or somewhere in between. For example, a high demand for junk bonds (bonds that have a high likelihood of defaulting) suggests a greedy market, while an above-average degree of volatility suggests a fearful market.)

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.

(Shortform note: According to experts, one way to mitigate fear when investing is to start with smaller investments and gradually work your way up to investing larger sums. Because fear is proportionate to the amount of money you’ve invested—after all, the more money that you invest, the more money that you could lose—slowly increasing your investment portfolio will help you cope with gradually increasing amounts of fear.)

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.

(Shortform note: In The Warren Buffett Way, Hagstrom explains Buffett’s idea that conformity doesn’t just influence investors, but also business leaders. According to Buffett, these leaders often succumb to the lemming factor and blindly follow industry trends, like constantly acquiring other companies, even when these trends are ultimately irrational. Thus, Buffett recommends investing in companies that are unafraid to look foolish and buck industry trends because they’re less likely to mirror these harmful tendencies.)

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.

(Shortform note: Excessive credulity in investors might stem from the ought-is fallacy—the fallacy of believing something because you want it to be true, not because of evidence that it is true. Informally known as wishful thinking, this fallacy explains why investors might purchase securities believing that their price can only increase, even though historical evidence suggests otherwise. After all, it’s natural for investors to want their securities to only increase in value.)

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.

(Shortform note: One possible reason why investors suffer from lack of imagination is that they rely too heavily on what Daniel Kahneman calls System 1 thinking. As opposed to System 2 thinking, which Kahneman defines as our ability to slowly and deliberately form judgments (like solving a complex math problem), System 1 thinking involves quick, intuitive judgments without voluntary effort (like performing basic arithmetic). According to Kahneman, System 1 thinking leaves us prone to extrapolating “patterns” from data that are actually random, like assuming a coin is rigged because it lands on tails several times in a row. Thus, investors that use System 1 thinking might assume market trends will continue indefinitely on the basis of recent data, although these data are often random subsets of larger data sets.)

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.

(Shortform note: Experts offer a variety of strategies for remaining on top of relevant market conditions like Marks suggests. For example, they point out that following news aggregators, such as Google News, can keep you aware of pertinent investing reports from a wide array of sources to ensure you don’t miss market developments. Moreover, they note that social media can provide direct access to the most important pieces of information about securities markets.)