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# A Dozen Ways to Apply the Lessons Taught in the Book “The Most Important Thing” by Howard Marks

1. “The expected result is calculated by weighing each outcome by its probability of occurring.”

the venture capital firm performs an “expected value” analysis which is: the weighted-average value for a distribution of possible outcomes. In other words, expected value is calculated by multiplying the payoff (i.e., stock price) for a given outcome by the probability that the outcome materializes.

Michael Mauboussin lays out a key part of the task for any investor in his usual clarifying manner in his essay “Ruminations on Risk”:

“Subjective probabilities describe an investor’s “degree of belief” about an outcome. These probabilities are rarely static, and generally change as evidence comes along. Bayes’s Theorem is a means to continually update conditional probabilities based on new information. Bayesian analysis is a valuable means to weigh multiple possible outcomes when only one outcome will occur. As Robert Hagstrom notes, the textbooks on Bayesian analysis suggest that if you believe that your assumptions are reasonable, it is perfectly acceptable to make your subjective probability of a particular event equal to a frequency probability. Thinking about the investing world probabilistically is critical to the margin of safety concept.”

2. “Many futures are possible, to paraphrase Dimson, but only one future occurs. The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck. The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many ‘alternative histories’ that were possible.”

Warren Buffett describes the approach:

“If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”

There is no absolute certainty in investing. Ever. There is no future. What exists now and in the past is what we have and when we look forward all we should think about is a probability distribution. In any form of investing you can be wrong even though you made the right decisions based on probability.

3. “Since other investors may be smart, well-informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others… which by definition means your thinking has to be different.” “To achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate. That’s not easy.”

4. “To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. 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.”

“A hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.”

“The most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high). These actions are lonely and… uncomfortable.”

“The thing I find most interesting about investing is how paradoxical it is: how often the things that seem most obvious – on which everyone agrees – turn out not to be true.”

5. “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. That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.”

6. “In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, “The prospective return isn’t high enough to warrant bearing all that volatility.” What they fear is the possibility of permanent loss.”

“Riskier investments are ones where the investor is less secure regarding the eventual outcome and faces the possibility of faring worse than those who stick to safer investments, and even of losing money. These investments are undertaken because the expected return is higher. But things may happen other than that which is hoped for. Some of the possibilities are superior to the expected return, but others are decidedly unattractive.” Risk comes from not knowing what you are doing. The best way to lower risk is to know what you are doing. It’s that simple. If riskier investments could be counted on to generate higher returns than they would not be riskier is the applicable famous Howard Marks quip on this point.

7. “First-level thinking says, ‘It is a good company; let’s buy the stock.’ Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.’ First-level thinking says, ‘The outlook calls for low growth and rising inflation. Let’s dump our stocks.’ Second-level thinking says, ‘The outlook stinks, but everyone else is selling in panic. Buy!’ First-level thinking says, ‘I think the company’s earnings will fall; sell.’ Second-level thinking says, ‘I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.’” Second level thinking is about finding value that others don’t appreciate. You can’t beat the crowd if you are the crowd.

8. “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. Isn’t that the essence of investing?”

“Processes in fields like history and economics involve people, and 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. Objective factors do play a large part in cycles, of course – factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions. But it’s the application of psychology to these things that causes investors to overreact or underreact, and thus determines the amplitude of the cyclical fluctuations.”

“Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.”

“A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy. The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, gets most investors into trouble.”

“It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheaply enough.”

Howard Marks believes that almost everything is cyclical.

9. “Overestimating what you’re capable of knowing or doing can be extremely dangerous – in brain surgery, transocean racing or investing. Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.”

“The actions of the ‘I know’ school are based on a view of a single future that is knowable and conquerable. My ‘I don’t know’ school thinks of future events in terms of a probability distribution. That’s a big difference. In the latter case, we may have an idea which one outcome is most likely to occur, but we also know there are many other possibilities, and those other outcomes may have a collective likelihood much higher than the one we consider most likely.”

Risk comes from not knowing what you are doing. The best way to avoid risk is to stick to situations where you know what you are doing and to work hard to expand the areas where you do know what you are doing by learning. One thing I have seen again and again in great investors is that they spend most of their time trying to determine what they don’t know.

10. “The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Thus, I suggest people try to ‘know the knowable.’”

11. “No rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly.” Venture capital is interesting in many ways, but perhaps most interesting is that it involves people who break rules.

12. “Where does an investment philosophy come from? The one thing I’m sure of is that no one arrives on the doorstep of an investment career with his or her philosophy fully formed. 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.”

#Risk

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