Investment book, a mini-review: The Most Important Thing: Uncommon Sense for the Thoughtful Investor, by Howard Marks

When I read a book within the genre of investment books by very successful practitioners sharing the secrets to their achievements, I always figure that if I take away one or two really new and good ideas from such exercise, then the book was worth reading in order to add those precious kernels to my depository of investment knowledge. Because I will always color-highlight such good ideas for future reference, I subsequently can judge where a book falls on the continuum that runs from hugely worthwhile at one end to complete dud at the other end by how much color is inside.

Several dozen highlighted passages are sprinkled throughout my copy of The Most Important Thing: Uncommon Sense for the Thoughtful Investor, by Howard Marks. Typically, these highlighted texts are just a few words or lines each. That, to me, is a good indicator of a truly great investment book. The fact that Marks, who is co-chairman and co-founder of Oaktree Capital Management, has produced a rather slender volume of 180 not-dense pages, only makes it all the better. I keep The Most Important Thing on a shelf at home that I walk by several times a day, and it is not uncommon for me to pick it up, flip through and skim a few pages, slide it back onto the shelf, and then continue on my way while thinking about how I can use that advice in my investment that day.

An emphasis on risk

Marks’ investment philosophy does not fall into a neat category, like “value” or “growth.” In contrast to most investment authors, who chiefly aim to convince their readers that they have the best ideas for how to achieve the greatest share price gains, Marks puts his greatest emphasis on risk. Indeed, he devotes three chapters in this book solely to understanding, recognizing, and controlling risk.

“Investing consists of exactly one thing: dealing with the future,” Marks writes. “And because none of us can know the future with certainty, risk is inescapable. Thus, dealing with risk is an essential – and I think the essential – element in investing.”

He goes on to point out three reasons why assessing risk is so important: 1) because risk “is a bad thing,” so it is smart to avoid or mitigate risk; 2) because, in deciding upon an investment, potential returns must be weighed against risks to be taken on, and so one obviously needs to understand both; and 3) because the success or failure of an investment can only be judged subsequently according to the risk undertaken. A fool can get lucky one time while taking a big risk, and a genius can run into bad luck despite taking all prudent precautions, but the fool is still a fool and the genius is still a genius.

Published in 2011, The Most Important Thing obviously is not a new book. Not surprisingly, then, Marks’ ideas are not new either. I believe these views are timeless, however, and I’ll give a few examples.

Contrarianism and second-level thinking

To outperform other investors, he explains, one needs to have contrarian opinions that are supported by what he terms “second-level thinking.” A consensus (i.e., non-contrarian) investor looks at what everybody else is buying and invests in the same. Maybe it’s a good company, but if millions are pouring billions into its stock, then that stock is almost surely overpriced relative to its value. A contrarian with second-level thinking, might find that the stock is overpriced and sell it instead.

But let’s go beyond the hot stock of the day and consider something more ordinary. The first-level thinker might look at a company, judge it to be a good one, and therefore buy the stock. Second-level thinking, though, involves digging deeper, finding the things that the first-level investors miss, and also comprehending whether the general consensus and market price for that company and its stock are right or wrong. Of course, it is one thing to have contrary opinions, but bucking the consensus only works if those opinions are not only divergent but also mostly correct.

“The difference in workload between first-level and second-level thinking is clearly massive,” Marks writes, “and the number of people capable of the latter is tiny compared to the number capable of the former.”

Understanding the present

It often has been sardonically observed that forecasting is hard – and especially about the future. Marks doesn’t believe in getting too hung up on the unknowable. “As difficult as it is to know the future,” he comments, “it’s really not that hard to understand the present… I believe those who are unaware of what’s going on around them are destined to be buffeted by it.”

Are investors overly optimistic, for example? Overly pessimistic? What about the talking heads in the media? Are they adding fuel to an overheated market? Are price/earnings ratios high or low compared to history? Are all kinds of new investment instruments and schemes being promoted, or, contrarily, are investors backing away from even plain vanilla and traditional investments? Is credit loose and capital plentiful, or are people and institutions getting careful with their money?

“All of these things are important,” Marks emphasizes, “and yet none of them entails forecasting. We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future. The key is to take note of things like these and let them tell you what to do. While the markets don’t cry out for action along these lines every day, they do at the extremes, when their pronouncements are highly important.”

Outperforming in bad times

Finally, I would point to Marks’ perspective on dark days in the market. Such periods inevitably come, and a smart investor will set up his or her portfolio accordingly. Most probably, that smart investor will run a defensive portfolio. When markets are soaring, it’s good enough to be average, maybe even a little below average, but performing below average in a hard downturn can mean getting wiped out.

“Oaktree portfolios are set up to outperform in bad times,” Marks relates, “and that’s when we think outperformance is essential. Clearly, if we can keep up in good times and outperform in bad times, we’ll have above-average results over full cycles with below-average volatility, and our clients will enjoy outperformance when others are suffering.”

This was sage advice in 2011, and I think it’s still good counsel today, but the fact is that there is nothing easy about creating a portfolio that does comparatively well through good times and bad. How, one must ask, does a person do that? Avoiding leverage, diversifying, conducting thorough analysis to avoid or prune out loser companies, shunning or limiting exposure to highly speculative investments are among the defensive measures mentioned in the book, but even modestly experienced investors already know these things.

Defensive investing in practice

Marks clearly recognizes that “defensive investing” is not so easy in actual practice. He tries to simplify this by advising the reader to “invest scared.” He says to “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.”

Now, I personally must disagree with Marks when he (rather uncharacteristically) uses words like “scared” and “worry,” but otherwise I share his sentiment and logic. At the end of the day, investing, at least of the active sort, is a very individual thing, and I believe successful investors benefit mainly from knowledge, experience, diligence, patience, and discipline. Studying The Most Important Thing can add only incrementally to these essential qualities, but, in my view, the book should rank near the top of any serious investor’s reading list, and I encourage every investor to pick up – and mark up – a copy for himself or herself.

I’d like to end this review with one final quote from Marks, because I think it is really important. In his closing chapter, he emphasizes that the smart investor “must have a good idea of what the thing you’re considering buying is worth.” The vast majority of individual investors fall short completely in this regard. They just do not have a clue. (That’s me speaking, by the way, but I am sure that Marks would not disagree.)

“To achieve superior investment results,” Marks concludes, “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.”