Imagine yourself in this situation.
You are overseeing the research group at one of the largest banks in the world. The stocks you recommended have plummeted mercilessly. Your boss approaches you with an option – quit research and start a fund focusing on debt, not equity. What would you do?
Well, Howard Marks grabbed that chance. In 1997, he was faced with this dilemma when at Citibank. The Nifty 50 stocks that he recommended had taken a beating. (Nifty Fifty refers to 50 popular blue-chip stocks that were listed on the New York Stock Exchange and widely regarded as solid growth stocks which investors paid extraordinarily high prices for.)
When Citibank’s CIO approached him to quit that role and start a fund focusing on convertible bonds, he leapt at the chance. A few years ago, Marks confessed in an interview with Bloomberg that if he had not been pushed out of research, he wondered where he would find himself today.
Incidentally, where does he find himself today?
A fabulously rich investment guru who has attained star status. His net worth, according to Forbes, is $1.8 billion.
A distressed-debt maven. His firm Oaktree Capital Management is one of the biggest distressed-debt investors in the world. As of December 31, 2013, it reported assets under management of $83.6 billion.
A brilliant writer. His memos have a somewhat cult following simply because his narrative artfully tackles seemingly boring investing trends and insights, and are loaded with astute commentary. When I see memos from Howard Marks in my mail, they're the first thing I open and read. I always learn something. Imagine such validation from none other than Warren Buffet himself!
He admits to the tendency of returning to a few topics time and again. But that is simply because of the frequency with which themes tend to recur in the investing world. He blames it on frail humanity that forgets the lessons of history and is doomed to repeat patterns of behaviour and make the same mistakes. For instance, in January last year, he commented on investor psychology that he never expected to change. He boldly asserted that fluctuations in investor attitudes toward risk contribute more to major market movements than anything else.
Not convinced?
Let’s follow his line of thought.
Why is it that you can invest in the best of companies and have a bad experience, or you can invest in the worst and have a good experience?
Because it is not asset quality that determines investment risk. Most of the risk in investing comes not from the companies, institutions or securities involved. It comes from the behaviour of investors.
Consider this. Economies rise and fall quite moderately. Companies see their profits fluctuate much more because of operating and financial leverage. But market gyrations make the former look mild. Why do the prices of stocks rise and fall much more than profits? The answer lies in the dramatic ups and downs in investor psychology.
There are no checks on the swings of investor psychology. Investors get crazily bullish and imagine no limits on prosperity, growth and appreciation. At other times, they get despondent and conclude that the “worst case” scenario they prepared for isn’t negative enough.
A too-high price can make something risky. A too-low price can make it safe. Naturally, it's naive to assume that price is the only factor at play. Deterioration of an asset can cause a loss, as can its failure to produce expected profits. But, all other things being equal, the price of an asset is the principal determinant of its riskiness.
The bottom line on this is simple: No asset is so good that it can’t be bid up to the point where it’s overpriced and thus dangerous. And few assets are so bad that they can’t become underpriced and thus safe. Since humans set security prices, it’s their behaviour that creates most of the risk in investing.
Next: How Howard Marks explains market movements