Friday, May 27, 2011

Howard Marks: How Quickly They Forget

I strongly suggest you read this piece. 
Today I bring the wisdom of Howard Marks. Another of those guys that you don't need to make introductions because readers SHOULD know who he is. Not for who he is, but for the wisdom he has accumulated over the years. And for he spreads this wisdom in elegant ways.

Again he touches a VERY SIMPLE and one of THE MOST IMPORTANT aspects of investing: caution.

Risk aversion is, for sure, one of the most important qualities of any portfolio manager. Yes, it is a quality. Portfolio managers are not in the market to prove the world they're macho. PMs are around to make money. But to make money without the risk of losing a lot of it on the way or outright losing a lot of it and getting fired. But usually managers think "well, it is my client's money, not mine, that I am losing". A lot of people think like that. And these are the people you shouldn't hire to manage your money. They like the asymmetry of making big bucks in a good year and losing nothing on a bad year. That brings in wreckless risk-taking.

In Brazil we have a saying that translated outright into english would mean: "He who has an ass fears". I wonder if some do not fear or do not care about their asses.
People who do not fear must be very talented in order to succeed through many years in the markets. They are usually not cautious enough about risk-adjusted returns. They're usually not cautious enough about how to execute a trade idea:

They like what everyone likes when everyone likes it. That usually means it is expensive.
They hate what everyone hates when everyone hates it. That usually means it is cheap.
And some choose blindly the way to get into their trades. They sell cheap options or they make huge positions to gain a few basis points on them. That leaves the door open for big unexpected losses.

Risk-averse managers do not leave this door open. Because they believe these losses are not unexpected.

Mr. Marks goes on to say:
In January 2004 I received a letter from Warren Buffett (how’s that for name dropping?) in which he wrote, “I’ve commented about junk bonds that last year’s weeds have become this year’s flowers. I liked them better when they were weeds.”

Warren’s phrasings are always the clearest, catchiest and most on-target, and I thought this Buffettism captured the thought particularly well. Thus for Oaktree’s 2004 investor conference we used the phrase “Yesterday’s Weeds . . . Today’s Flowers” as the title of a slide depicting the snapback of high yield bonds. It showed the 45% average yield at which a sample of ten bonds could have been bought during the Enron-plus-telecom meltdown of 2002 and the 6% average yield at which they could have been sold in 2003; on average, the yields had fallen by 87% in just thirteen months. The idea went full-circle in 2005, when Warren used our slide at the Berkshire Hathaway annual meeting to illustrate how rapidly things can change in the world of investing.

And that’s the point of this memo. Asset prices fluctuate much more than fundamentals. This happens because, rather than applying moderation and balancing greed against fear, euphoria against depression, and risk tolerance against risk aversion, investors tend to oscillate wildly between the extremes. They apply optimism when things are going well in the world (elevating prices beyond reason) and pessimism when things are going poorly (depressing prices unreasonably). Shortness of memory plays a major part in abetting these swings. If investors remembered past bubbles and busts and their causes, and learned from them, the swings would moderate. But, in short, they don’t. And they may be forgetting again.

High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now strike them as good buys at twice the price. The swing of this pendulum recurs regularly and creates some of the greatest opportunities to lose or gain. Thus we must always be mindful.

Since I am rather young I loved to read this part:
First, there’s investor demographics. When the stock market declined for three straight years in 2000-02, for example, it had been almost seventy years since that had last happened in the Great Depression. Clearly, very few investors who were old enough to experience the first such episode were around for the second.
For another example, I believe a prime contributor to the powerful equity bull market of the 1990s and its culmination in the tech bubble of 1999 was the fact that in the quarter century from 1975 through 1999, the S&P 500 saw only three minor annual declines: 6.4% in 1977, 4.2% in 1981, and 2.8% in 1990. In order to have experienced a bear market, an investor had to have been in the industry by 1974, when the index lost 24.3%, but the vast majority of 1999’s investment professionals doubtless had less than the requisite 26 years of experience and thus had never seen stocks suffer a decline of real consequence.
This is just brilliant. And this is, for sure, one of the reasons to why I give so much importance to reading about many of the famous investors of the world and history. These guys will tell you what it was like 'back then'. They will tell you 'how I got screwed back then'. And also 'what I learned back then'. The single most commented aspect of investing that I found through the tens of books I read was: risk-aversion is a quality.

And the final touch:
So if you could ask just one question regarding an individual security, asset class or market, it should be “is it cheap?” Oaktree’s investment professionals try to ask it, in different ways, every day
No further questions, your honor.
It is very important to keep in mind these basic aspects: risk-aversion + buying what is cheap.

Again, I strongly suggest you read this piece.
Oaktree Capital Management - 2011 05 25 - Howard Marks - How Quickly They Forget

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

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