Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 9 “The Most Important Thing Is…Awareness of the Pendulum”

Psychology, Risk, When To Buy, When To Sell

As the title of this chapter gives away, much of Marks’ comments emphasize the importance of awareness of market participants’ psychology, specifically their attitudes toward risk, which creates optimal conditions for buying or selling (depending on the “location” of the pendulum). For more on this, be sure to read a previous discussion on Howard Marks’ concept of the “perversity of risk” and resulting risk manifestation.

“Investment markets follow a pendulum-like swing:

• Between euphoria and depression;
• Between celebrating positive developments and obsessing over negatives…
• Between overpriced and underpriced.”

“…the pendulum also swings with regard to greed versus fear; willingness to view things through an optimistic or a pessimistic lens; faith in developments that are on-the-come; credulousness versus skepticism; and risk tolerance versus risk aversion.

The swing in the last of these – attitudes toward risk – is a common thread that runs through many of the market’s fluctuations. Risk aversion is THE essential ingredient in a rational market…and the position of the pendulum with regard to it is particularly important. Improper amounts of risk aversion are key contributors to the market excesses of bubble and crash.”

When To Buy

“Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.”

“The swing back from the extreme is usually more rapid – and thus takes much less time – than the swing to the extreme.”

The comment regarding the speed of swing back from the extremes is interesting.

Mariko Gordon of Daruma Capital (who writes wonderfully insightful and entertaining letters) once pointed out that opportunities “tend to make themselves available between the two extremes of ‘fire hose’ and ‘dripping faucet’ and that what ultimately matters is “having a sound strategy for uncovering the best when ideas are as plentiful as mushrooms after a rain, and locating the gems when the pendulum inevitably swings back the other way.”

I think both Marks and Gordon would agree that it’s not only the ability to identify when the pendulum reaches the extremes that counts, but also the ability to act quickly and take advantage of those rare and fleeting moments.

Catalyst

“The market has a mind of its own, and its changes in valuation parameters, caused primarily by changes in investor psychology (not changes in fundamentals), that account for most short-term changes in security prices. This psychology, too, moves like a pendulum.”

Stanley Druckenmiller once commented that: “I never use valuation to time the market…Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction…The catalyst is liquidity…”

Is investor psychology (one of) the initial catalyst(s) that impacts liquidity, which then drives valuation?

Risk, Expected Return, Capital Preservation, Opportunity Cost

“In my opinion, the greed/fear cycle is caused by changing attitudes toward risk. When greed is prevalent, it means investors feel a high level of comfort with risk and the idea of bearing it in the interest of profit. Conversely, widespread fear indicates a high level of aversion to risk. The academics consider investors’ attitudes toward risk a constant, but certainly it fluctuates greatly. Finance theory is heavily dependent on the assumption that investors are risk-averse. That is, they ‘disprefer’ risk and must be induced – bribed – to bear it, with high expected returns.”

“…I’ve recently boiled down the main risks in investing to…: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both. In an ideal world, investors would balance these two concerns…In 2005, 2006, and early 2007, with things going so swimmingly and the capital markets wide open, few people imagined that losses could lie ahead. Many believed risk had been banished. Their only worry was that they might miss an opportunity; if Wall Street came out with a new financial miracle and other investors bought and they didn’t…since they weren’t concerned about losing money, they didn’t insist on low purchase prices, adequate risk premiums or investor protection. In short, they behaved too aggressively.”

2005-2007 provides a great example of how misjudgments in risk and expected return can also cloud estimations of opportunity cost (which is a function of expected risk and return predictions). This caused investors to think the opportunity cost of not investing high – when in fact the exact opposite was true – leading to detrimental results.