Howard Marks use the memo to elaborate his investment philosophy, explain the workings of finance and his standpoint on recent events.
Investing can’t be reduced to an algorithm and turned over to a computer.
Even the best investors don’t get it right every time. Psychology plays a
major role in markets, and because it’s highly variable, cause-and-effect
relationships aren’t reliable.
Anyone can achieve average investment performance—just invest in an index fund
that buys a little of everything. That will give you what is known as
“market returns”—merely matching whatever the market does. But
successful investors want more. They want to beat the market.
Beating the market matters, but limiting risk matters just as much. Ultimately, investors have to ask themselves whether they are interested in relative or absolute returns. Losing 45 percent while the market drops 50 percent qualifies as market outperformance, but what a pyrrhic victory this would be for most of us. To accomplish that, you need either good luck or superior insight.
The subtext here is that you must be patient and give yourself
ample time—you’re not looking for short-term windfalls but for long-term, steady returns.
In some pursuits, getting to the front of the pack means more schooling, more time in the
gym or the library, better nutrition, more perspiration, greater stamina or
better equipment. But in investing, where these things count for less, it
calls for more perceptive thinking, the so-called second level. Would-be investors can take courses in finance and accounting, read
widely and, if they are fortunate, receive mentoring from someone with a
deep understanding of the investment process. But only a few of them
will achieve the superior insight, intuition, sense of value and awareness
of psychology that are required for consistently above-average results.
Doing so requires second-level thinking.
Howard Marks‘ definition of the second-level thinking is based on the reasoning that "Since other investors may be smart, well-informed and highly computerized, you
must find an edge they don’t have. You must think of something they
haven’t thought of, see things they miss or bring insight they don’t
possess. You have to react differently and behave differently."
All first-level thinkers investors can’t
beat the market since, collectively, they are the market. You can’t do the same things others do and expect to outperform.
The attractiveness of buying something for less than it’s worth
makes eminent sense. So how is one to find bargains in efficient
markets? You must bring exceptional analytical ability, insight or
foresight. But because it’s exceptional, few people have it.
Here, Marks successfully links market efficiency with second-level
thinking. This statement is a very important contribution to investment literature because
few commentators have attempted to link academic work on market theory with a
pragmatic view of how to actively manage assets.
Psychological influences are a dominating factor governing investor
behavior. They matter as much as—and at times more than—underlying value in
determining securities prices.
It is also critical to spend time trying to fully understand the
incentives at work in any given situation. Flawed incentives can often explain irrational,
destructive, or counterintuitive behaviors or outcomes.
One or two good years prove nothing; chance alone can
produce just about any result. Statisticians insist nothing can be
proved with statistical significance until you have enough years of data.