The Most Important Thing Illuminated

Text in black are quotes; text in green are my notes. I sometimes write in Spanish.

• like to say, “Experience is what you got when you didn’t get what you wanted.” #

• Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times. #

• In my view, that’s the definition of successful investing: doing better than the market and other investors. #

• You can’t do the same things others do and expect to outperform. #

• In theory there’s no difference between theory and practice, but in practice there is. #

• “Being too far ahead of your time is indistinguishable from being wrong.” #

• Individual investors need to think of this “most important” point with every investment decision. No matter how good an investment sounds, if price has not yet been considered, you can’t know if it is a good investment. #

• If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value. #

• Believe me, there’s nothing better than buying from someone who has to sell regardless of price during a crash. Many of the best buys we’ve ever made occurred for that reason. #

• Since buying from a forced seller is the best thing in our world, being a forced seller is the worst. That means it’s essential to arrange your affairs so you’ll be able to hold on—and not sell—at the worst of times. #

• Over the years leverage has been associated with high returns, but also with the most spectacular meltdowns and crashes. #

• “The market can remain irrational longer than you can remain solvent.” #

• Riskier investments are those for which the outcome is less certain. That is, the probability distribution of returns is wider. When priced fairly, riskier investments should entail: •    higher expected returns, •    the possibility of lower returns, and •    in some cases the possibility of losses. #

• Rather than volatility, I think people decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return. To me, “I need more upside potential because I’m afraid I could lose money” makes an awful lot more sense than “I need more upside potential because I’m afraid the price may fluctuate.” No, I’m sure “risk” is—first and foremost—the likelihood of losing money. #

• “the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation.” #

• “Risk means more things can happen than will happen.” #

• “There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” That’s one of the most important things you can know about investment risk. #

• Understanding uncertainty: Investing requires us to make decisions about the future. Usually we do so by assuming it will bear a resemblance to the past. But that’s far from saying outcomes will be distributed the same as always. Unusual and unlikely things can happen, and outcomes can occur in runs (and go to extremes) that are hard to predict. Underestimating uncertainty and its consequences is a big contributor to investor difficulty. #

• The received wisdom is that risk increases in the recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions. #

• Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do. #

• HOWARD MARKS: The riskiest things: The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real. #

• CHRISTOPHER DAVIS: That is, high price both increases risk and lowers returns. #

• CHRISTOPHER DAVIS: A good analogy to this is the studies that show there are more traffic fatalities among drivers and passengers in SUVs than in compact cars despite SUVs’ being bigger and more sturdily built. Drivers of SUVs believe they’re not at risk in case of an accident, and this leads to riskier driving. The feeling of safety tends to increase risk while the awareness of risk tends to reduce it. #

• Risk cannot be eliminated; it just gets transferred and spread. #

• The investment thought process is a chain in which each investment sets the requirement for the next. #

• Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as their psychology strengthens and they become bolder and less worried, investors cease to demand adequate risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it. #

• When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price. #

• This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. #

• risk control can be present in good times, but it isn’t observable because it’s not tested. Ergo, there are no awards. Only a skilled and sophisticated observer can look at a portfolio in good times and divine whether it is a low-risk portfolio or a high-risk portfolio. #

• Bottom line: risk control is invisible in good times but still essential, since good times can so easily turn into bad times. #

• I’ve said for years that risky assets can make for good investments if they’re cheap enough. #

• there are two concepts we can hold to with confidence:   •   Rule number one: most things will prove to be cyclical. •   Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one. #

• 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. #

• As The Economist said earlier this year, “the worst loans are made at the best of times.” #

• Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on. #

• In the end, trees don’t grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical. #

• When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so. #

• When investors in general are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-averse, prices can offer more return than risk. #

• The swing back from the extreme is usually more rapid—and thus takes much less time—than the swing to the extreme. (Or as my partner Sheldon Stone likes to say, “The air goes out of the balloon much faster than it went in.”) #

• Time and time again, the postmortems of financial debacles include two classic phrases: “It was too good to be true” and “What were they thinking?” #

• Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron. #

• The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled. #

• “investment is the discipline of relative selection.” #

• 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, get most investors into trouble. #

• There isn’t always a pendulum or cycle extreme to bet against. Sometimes greed and fear, optimism and pessimism, and credulousness and skepticism are balanced, and thus clear mistakes aren’t being made. Rather than obviously overpriced or underpriced, most things may seem roughly fairly priced. In that case, there may not be great bargains to buy or compelling sales to make. JOEL GREENBLATT: This is one of the hardest things to master for professional investors: coming in each day for work and doing nothing. #

• there are products that can’t be differentiated, and economists call them “commodities.” They’re goods where no seller’s offering is much different from any other. They tend to trade on price alone, and each buyer is likely to take the offering at the lowest delivered price. Thus, if you deal in a commodity and want to sell more of it, there’s generally one way to do so: cut your price. #

• PAUL JOHNSON: I feel strongly that running through this checklist twice a year would allow an investor to keep tabs on the swing of the market’s pendulum. After a decade, the investor would have a rich database of past market swings from which to draw. I wish I had started such a list ten years ago. #

• the quality of a decision is not determined by the outcome. The events that transpire afterward make decisions successful or unsuccessful, and those events are often well beyond anticipating. #

• In the long run, there’s no reasonable alternative to believing that good decisions will lead to investment profits. In the short run, however, we must be stoic when they don’t. #

• There are old investors, and there are bold investors, but there are no old bold investors. #

• In other words, in amateur tennis, points aren’t won; they’re lost. I recognized in Ramo’s loss-avoidance strategy the version of tennis I try to play. #

• At Oaktree, on the other hand, we believe firmly that “if we avoid the losers, the winners will take care of themselves.” That’s been our motto since the beginning, and it always will be. #

• I learned a lot from my favorite fortune cookie: The cautious seldom err or write great poetry. #

• An investor needs do very few things right as long as he avoids big mistakes. WARREN BUFFETT #

• Thus, it’s important to return to Bruce Newberg’s pithy observation about the big difference between probability and outcome. Things that aren’t supposed to happen do happen. Short-run outcomes can diverge from the long-run probabilities, and occurrences can cluster. For example, double sixes should come up once in every 36 rolls of the dice. But they can come up five times in a row—and never again in the next 175 rolls—and in the long run have occurred as often as they’re supposed to. #

• it’s worth noting that the assumption that something can’t happen has the potential to make it happen, since people who believe it can’t happen will engage in risky behavior and thus alter the environment. #

• Leverage magnifies outcomes but doesn’t add value. It can make great sense to use leverage to increase your investment in assets at bargain prices offering high promised returns or generous risk premiums. But it can be dangerous to use leverage to buy more of assets that offer low returns or narrow risk spreads—in other words, assets that are fully priced or overpriced. It makes little sense to use leverage to try to turn inadequate returns into adequate returns. #

• When there’s nothing particularly clever to do, the potential pitfall lies in insisting on being clever. #

• In good years in the market, it’s good enough to be average. Everyone makes money in the good years, and I have yet to hear anyone explain convincingly why it’s important to beat the market when the market does well. No, in the good years average is good enough. #

• I encourage you to think about “good-enough returns.” It’s essential to realize that there are returns so high that they aren’t worth going for and risks that aren’t worth taking. #

• The superior investor never forgets that the goal is to find good buys, not good assets. #

• “Being too far ahead of your time is indistinguishable from being wrong.” It can require patience and fortitude to hold positions long enough to be proved right. #

• Most investors think diversification consists of holding many different things; few understand that diversification is effective only if portfolio holdings can be counted on to respond differently to a given development in the environment. #