This article was originally published on ETFTrends.com.
The best lessons are about learning what not to do. Great investors like Buffett and Klarman and others drill home the point of avoiding big mistakes. They understand how a loss can be compounded by a mental or emotional misstep, making recovery that much harder.
Like a lot of us, the great investors start out learning this first-hand. Painful experience — from time in the market — can be a great teacher. Mistakes are part of the process.
But they quickly realize there are more efficient, less painful ways of learning from other’s mistakes. As Howard Marks says, you just have to pay attention:
The markets are a classroom where lessons are taught every day. The keys to investment success lie in observing and learning.
The great thing about hindsight is, it always points out what everyone did wrong.
At the end of 2007, Howard Marks relayed the many lessons he’d seen over the years, at it related to the financial crisis. He realized those lessons weren’t limited to the crisis but contributed in some way to investor losses in all market cycles.
So he shared the lessons again in his book, The Most Important Thing:
To much capital availability makes money flow to the wrong places.When capital is scarce and in demand, investors are faced with allocation choices regarding the best use of their capital, and they get to make their decisions with patience and discipline. But when there’s too much capital chasing too few ideas, investments will be made that do not deserve to be made.
When capital goes where it shouldn’t, bad things happen. In times of capital market stringency, deserving borrowers are turned away. But when money’s everywhere, unqualified borrowers are offered money on a silver platter. The inevitable results include delinquencies, bankruptcies, and losses.
When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin of error. When people want to buy something, their competition takes the form of an auction in which they bid higher and higher. When you think about it, bidding more for something is the same as saying you’ll take less for your money. thus, the bids for investments can be viewed as a statement of how little return investors demand and how much risk they’re willing to accept.
Widespread disregard for risk creates great risk. “Nothing can wrong.” “No price is too high.” “Someone will always pay me more for it.” “If I don’t move quickly someone else will buy it.” Statements like these indicate that risk is being given short shrift. This cycle’s version saw people think that because they were buying better companies or financing with more borrower-friendly debt, buyout transactions could support larger and larger amounts of leverage. This caused them to ignore the risk of untoward developments and the danger inherent in highly leveraged capital structures.
Inadequate due diligence leads to investment losses. The best defense against is thorough, insightful analysis and insistence on what Warren Buffett calls “margin of error.” But in hot markets, people worry about missing out, not about losing money, and time-consuming, skeptical analysis becomes of the province of old fogeys.
In heady times, capital is devoted to innovative investments, many of which fail the test of time. Bullish investors focus on what might work, not what might go wrong. Eagerness takes over from prudence, causing people to accept new investment products they don’t understand. Later, they wonder what they could have been thinking.
Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. It’s easier to assess the return and risk of an investment than to understand how it will move relative to others. Correlation is often underestimated, especially because of the degree to which it increases in crisis. A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, nonfundamental factors such as margin calls, frozen markets and a general rise in risk aversion can become dominant, affecting everything similarly.
Psychological and technical factors can swamp fundamentals. In the long run, value creation and destruction are driven by fundamentals such as economic trends, companies’ earnings, demand for products and the skillfulness of management. But in the short run, markets are highly responsive to investor psychology and the technical factors that influence the supply and demand for assets. In fact, I think confidence matters more than anything else in the short run. Anything can happen in this regard, with results that are both unpredictable and irrational.
Markets change, invalidating models. Accounts of the difficulties of “quant” funds center on the failure of computer models and their underlying assumptions. The computers that run portfolios attempt primarily to profit from patterns that held true in past markets. They can’t predict changes in those patterns; they can’t anticipate aberrant periods; and thus they generally overestimate the reliability of past norms.
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.
Excesses correct. When investor psychology is extremely rosy and markets are “priced to perfection” — based on an assumption that things will always be good — the scene is set for capital destruction. It may happen because investors’ assumptions turn out to be too optimistic, because negative events occur, or simply because too-high prices collapse of their weight.
Most of these eleven lessons can be reduced to just one: be alert to what’s going on around you with regard to the supply/demand balance for investable funds and the eagerness to spend them.
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