Howard Marks & The Foundational Elements of Intelligent Investment
"One of the biggest mistakes you can make in life — but especially in investing — is to assume that you are smart and everybody else is dumb."
Howard Marks of Oaktree Capital Management — renowned for his insightful investment memos and ability to distill complex ideas into simple, practical wisdom — spoke at The Church in Sag Harbor, New York, last summer.
Over the course of an hour, Marks walked the crowd through what he considers the foundational elements of intelligent investment. All in all, he discussed the Efficient Market Hypothesis, investor psychology, market cycles, risk vs. reward, artificial intelligence, cryptocurrency, and even his favorite Munger-ism.
As you can see in the photo above, Marks used a whiteboard at various points to illustrate his lessons. But, unfortunately, these notes are not visible in the video — and, anyway, would not translate well to a written transcript. As such, I’ve tried to add context and descriptions where needed.
Howard Marks: I’m going to talk about three aspects of investment theory which I think are absolutely foundational, which most laypeople have never heard about, but which I think are essential to be an intelligent investor.
Three foundational elements [of intelligent investment].
The first is something called the Efficient Market Hypothesis. Basically, what it says is that there are millions of investors and they are — most of them or some of them — intelligent, literate, numerate, objective, rational, computerized, and highly motivated to make money. And their joint efforts cause stocks to be fairly valued.
If there is a stock out there that is undervalued and people read about it, they figure out [it is undervalued], they bid for it in the market, they go out to buy it because it’s a bargain — and their buying causes the price to go up.
If there’s a stock out there and it’s too high, they study it, they realize that it’s too high, and they sell it or sell it short — and their action causes the price to go down.
So the bargains get raised in price, the overpriced securities get underpriced, and eventually the prices converge with something called fair value.
There’s this thing called fair value. [Marks draws graph on whiteboard.] This is dollars [on the y-axis]. I’m not going to tell you what this [on the x-axis] is right now. But securities are priced like this. [Marks points at scattered spots all over the graph.] Some are below fair value and some are above fair value.
When all of these people that I mentioned study the market, they buy the cheap ones and they cause the prices to converge with fair value — and they sell the expensive ones and cause their prices to converge with fair value. So, by the end of this process, it just looks like that [with everything at fair value]. All of the prices, all of the stocks are on this line, the so-called “efficient frontier”.
Now, what’s on this x-axis here is risk.
There’s an assumption, which I’ll talk [about] in the second chapter, that people are risk-averse and because they are risk-averse, if they’re going to make risky investments they have to be tempted with incremental return.