Invest Like the Best with Patrick O'Shaughnessy - Howard Marks - Embracing the Psychology of Investing - [Invest Like the Best, EP. 231]

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Starting point is 00:02:13 visit pxos.com forward slash Patrick. That's pAXOS.com forward slash Patrick. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest Like the Best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at join colossus.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management.

Starting point is 00:02:53 All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunsi asset management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaunosy Asset Management may maintain positions and the securities discussed in this podcast. My guest today is Howard Marks, co-founder of Oak Tree Capital, a leading investment manager and one of the world's largest distressed debt investors. In our conversation, we discussed takeaways from the market sell-off and rapid recovery in 2020, the importance of assessing both quantitative and qualitative factors in markets and the benefits Howard has realized from a career of writing. I hope you

Starting point is 00:03:35 enjoy this great conversation with Howard Marks. So Howard, I've toyed with where we might begin what will surely be a wide-ranging conversation. I'm going to start really broad, which is to ask you, if you think forward 50 or 100 years, what big ideas of yours that you've returned to over your career are you most confident will stand the test of time? I actually think that in terms of specific contributions. The greatest one I've made is the modification of the capital market line through the imposition of some probability distributions to indicate that not only when risk increases does expected return increase, but so does uncertainty. And, you know, I indicate that by superimposing these bell-shaped curves turned on their sides. And I think that it's an extremely

Starting point is 00:04:28 good way to understand the meaning of risk, frankly, but I'm not aware that anybody's picked it up and I'm not aware that anybody ever will. I think that's very important. Can you describe how you view the difference between risk and uncertainty, those two key categories for investors? And what do you think is the right frame of mind, maybe for equity investors especially who tend to have to deal with more uncertainty than, say, credit lenders? What do you think the right frame of mind is around uncertainty? Should it something that equity investors are actively trying to gain more exposure to, maybe than they tend to, as a source of strong returns over time? I think the understanding of risk is in many ways incorrect. And I've had people say my goal is to have a high risk portfolio. And I think

Starting point is 00:05:18 that's the wrong way to think about it. I think the goal is to have a high return portfolio. and you accept that you may have to take more risk to get it. Do you think it's an oversimplification to think of equity investing as the what could go right business and debt investing as the what could go wrong business? It's an oversimplification. It's not an outrageous oversimplification for the main reason that, yes, these are the things that people are preoccupied with. It's true in fixed income, the way you're preoccupied with what can go wrong because the only thing

Starting point is 00:05:53 it can go right for the most part is you get paid. If you buy an 8% bond at par, pretty much the best you can do is get paid 8% at maturity. But there are lots of degrees of failure. You might get 80 cents or 60 cents or 40 cents or 20 cents in a bankruptcy. So yes, Graham and Dodd in the 1940 edition of security analysis called fixed income investing at negative art. And I think what they meant is that since all 8% bonds, 8%, and if there are 100, bonds of which 90 will pay, it doesn't matter which of the 90 you buy because the return is all the same. They all make 8%. The only thing it matters is that you don't buy the 10 that don't pay. So you increment your performance not through what you buy, but through what you exclude. And that's

Starting point is 00:06:41 why it's a negative art. Now, that same is not true of equity investing. When you say what can go right, that is, I think people are preoccupied by what can go right when they buy stocks. But clearly, There's a lot that can go wrong. So while it's okay in bond investing to ignore the upside, not okay in equity investing to ignore the downside. Putting that lens on today's market, do you think it's fair that paying attention to that downside in equities tends to wane late in equity cycles and that the world we're living in in 2021, at least until the last few months where some things have gone down a lot,

Starting point is 00:07:19 that that was sort of the mindset you're hearing crazy valuations of price to address market or these kind of absurd valuation ratios. Have you seen that through your career that towards the end of very exciting equity upruns, that people stop wondering what could go wrong more? The initial of an up cycle. When you get improvement in the economy and good performance of the companies and good performance of the stocks, you get increasing optimism, increasing enthusiasm, decreasing skepticism, increasing confidence. And so people tend to think more of the companies and assets that have the greatest upside story, shall we say. They tend to engage in what we were told in high school literature classes is the willing suspension of this belief.

Starting point is 00:08:09 And they compete to own the companies and assets with the greatest upside potential. by bidding them up. And what you're asking me is, is the latter half of the up cycle, is it actually the latter half of the up cycle? And the answer is yes. The latter part of the up cycle comes when everything's going well. And people tend to accept the trees will grow to the sky. And one of the greatest adages I ever learned in the early 70s was that there are three

Starting point is 00:08:44 stages to the bull market. The first stage when only a few intelligent, unusually intelligent people appreciate that there could be improvement. The second stage when most people accept that improvement is taking place. And the third stage, when everybody believes that everything will get better forever. And clearly in the third stage, that's when you get people paying the most or far off uncertain potential, which is what you describe. Living through 2020 and now into 2021, has surely been one of the most interesting markets that anyone's ever seen. You've seen a lot of fascinating markets in your career. And I think your memo output in 2020 was prolific. You wrote a lot about the market. How does this 18-month period stack up to your own experience with market history

Starting point is 00:09:32 in terms of its uniqueness and the fact that we had a vicious bear market very quickly and then a pretty similarly vicious bull market? It's just a strikes me as unusual relative to history. And I'm curious, your read on it. Mark Twain said history does not repeat, but it does rhyme. And if you look at the cycle of 2020, it doesn't rhyme with very much. The main reason is because in every other prices that I lived through the up cycle, down cycle, let's say, the cause was endemic. The cause came from within. And most cycles, I think, occur because people, become over-optimistic and everything departs from the specular trend line in the direction of excess. And as I mentioned, people become excited and enthusiastic. And eventually, their excitement and

Starting point is 00:10:28 enthusiasm take things to an excess. And in the long run, that excess is not sustainable. And so you get a correction back toward the trend line. You get a downward correction. But of course, it goes through the trend line to an excess on the downside, which ultimately turns out to be unsustainable, so you get a correction back up toward the trend line. So I think cycles are best understood, not as ups and downs, which sounds kind of random, but as excesses and corrections. The point is that what happened in 2020 was obviously not the result of excess optimism. It happened because for an exogenous reason, that is, we were hit by a meteor from out of space in the form of a pandemic. That's what caused the downturn, along with the fact that in order to fight the pandemic,

Starting point is 00:11:16 the authority closed business to keep people from infecting each other. So you had, I would say, a man-made recession prompted by an exogenous event. And then you had an upturn, which was engineered by the Fed and the Treasury, not because the upturn did not occur because things got so bad that they were unsustainable. and there was a natural regression back toward the trend line of the economy. The recovery occurred because the Fed and Treasury did things that caused it. There's no similarity to pass cycles in terms of cause, speed, amplitude, and impact. You had to learn a whole new game plan.

Starting point is 00:11:59 Do you think that that entire new game plan affects all investors going forward? Because you've written a lot in the past about the role of liquidity in market. famously in the Great Depression monetary supply contracted. The toolkit seems to be fight every battle by flooding liquidity into the system. And so how do we adjust our model of the world going forward? I think that there's every possibility that people will look at the last two experiences, which are 2020 and 2008, the gold financial crisis, and say the Fed obviously has the fire power to prevent every downturn in the economy, and they should do so. Some people are think that way. I'm not confident on this subject because I'm not a professional economist or Fed

Starting point is 00:12:43 watcher. And you know, you should beware of analogies. But in the forestry business, if there's a small fire, they let it occur. Sometimes they even cause some small fires to burn up the fuel that lies on the forest floor. And if you don't permit any small forest fires, when you finally have one that you can't put out right away, you're going to have a doozy because of all the accumulated fuel on the forest floor. I believe that if they prevent every recession that will give rise to such excesses on the high side, it will be, as I say, unsustainable and will cause a recession. And that's going to be a doozy. So it just seems to me that if I were running Fed, which I'm absolutely unqualified to do, I would opt for leaving it alone most of the time, the economy and having it do

Starting point is 00:13:34 what it does naturally. All of us in the investment business, I don't think there are any socialists in the investment business. We're all in the investment business because we believe in the efficacy of the free market as an allocator of resources. So if you do, then shouldn't you leave the economy and the capital market alone as much as you can so that it can freely allocate resources? So I guess I would not be an activist. Now, having said that, what they did in 20, they had to do. And if they hadn't done it, we'd have a worldwide depression now. And I made the point in one of my memos that just because something has negative possible ramifications doesn't mean you shouldn't do it. But in this case, they had to do it. But it did have, in my opinion,

Starting point is 00:14:25 negative possible ramifications. So they should try to avoid doing it again anytime soon. And I'm a visual person. So I come up with visual images. And my visual image for the economy is it's kind of like a ball at the top of a water spout. And as long as the water spout is strong, the ball stays up in the air, stays out of the water. So the Fed levitates the economy through the water spout, which consists of liquidity. But it only stays up as long as the Fed is injecting liquidity. And is it appropriate for the Fed to inject incremental liquidity on a permanent basis. One of the things that you've written a lot about is the role of psychology. You already mentioned it in the sort of third stage, if you will, of the bull market.

Starting point is 00:15:14 When at market extremes, do you think that psychology is even more interesting for investors to consider than the quantitative data about companies or markets or PE ratios or what have you? I think so because the quantitative data is what's right. and proper in the long run. In other words, you're helping the market to act as a weighing machine, as Ben Graham said, an intelligent investor. But in the short term, it's a voting machine to get a handle on how people are voting and how they're likely to vote in the future. And whether that'll change, I think you have to study psychology, which is, let's say, what determines who wins the voting, who wins the popularity contest.

Starting point is 00:16:00 So I think that studying psychology gives you a great advantage. And I think it's incumbent on the investor to understand it. If you want to understand your market, you have to understand the motivation of the people in it because that's all the market is. I would say that my market calls have, if you lead the memos in which I talked about how I felt about the market at various junctures, there's not a lot of numbers in there. I don't say that the PE ratio is too high or too low and that the earnings estimates are too high or too low. What I say usually is psychology is too buoyant or it's too negative. And if you look at over time at the memos like the race to the bottom in February 2007, which said that the market was being too positive, or let's say it's all good from, I think, July 1st or 7,

Starting point is 00:16:50 they were all talking about the fact that people are thinking too positive. And then I wrote a memo called The Limits to Negativism in October 2008, which was the low point of the cycle, and it was talking about the fact that people are being too negative. So to me, it's a great indicator, but it's not sufficient. It's necessary, but not sufficient. And at the present time, everybody's wrestling with the question of whether we're in a bubble or not. And I have not, there are a lot of the traditional indicators of bubbles are out there. I've had trouble, including that stocks have a lot of vulnerability because I see very good economic news for the next let's say at least nine months. And I find it hard to see the market collapse while very good

Starting point is 00:17:36 economic news is being announced. So I'm not relying just on psychology, but I think it's important to understand when the market is experiencing psychological excesses. What are my favorite things that you've written about more recently is a series of conversations that you've had with your son, Andrew, on sort of the nature of value? This is obviously the thing that all certainly equity investors are looking for. And you've written and thought so much about this. I would just love to hear what led to this series of conversations. What have you learned from them talking to your son? Well, what led to them was being cooped up with him out in California. And we came out here on March 6th to do our client conference. And we canceled it, but decided to

Starting point is 00:18:19 conduct it and videotape it and live stream it. That was on the 11th, which we did. And then at lunchtime on the 11th is really when we locked down for the next 14 months or so. And Andrew and his family came out on the 13th, two days later, and moved in with us. And we stayed that way for a few months. It was our conversations during that period, and then over the balance of the year, which led to those discussions. And the main thrust of the discussions, which I accepted, was that Value investing had become theologized, that is, it had been turned into a theology, which was very formalized and rigorous but limiting. And so, for example, value investing has to have a high degree of predictability, a high degree of quantifiability. Most of the

Starting point is 00:19:14 appeal based on the present earnings and the present assets, and rather little of the appeal based on, or I should say future potential for large scale increases in assets or earnings, low price earnings ratio, low price to book, those kinds of things. And by the way, I think it was accepted as an article of faith by most value investors that we don't invest in technology. And of course, they're emulating Buffett in that regard. I don't think that just low valuation multiples is enough because a lot of low valuation multiples are deserved. It has to be more for your money. And that's what the value investor should be looking for. And that's what the growth investor should be looking for. The best, the best opportunities to buy assets in terms of what you

Starting point is 00:20:05 get for your money. And Buffett has been in quote saying, we are not value investors or growth investors. We are investors. So you can't say, I'm an investor. And I, I, exclude from my portfolios the parts of the world that are subject to change. And once you stop saying that, you by definition get involved in growth and parts of the economy that are changing rapidly. That's one of the key conclusions of that discussion. The other key conclusion was that it probably takes a lot of expertise to judge the faster growing companies and certainly the companies that are involved in technology and like sciences and all those kinds of things, if you're going to get involved in the fast-growing parts of the economy like technology,

Starting point is 00:20:52 you need some expertise. And you can't talk about these companies based on a superficial take. You have to get deeply involved and develop an expert view. And so I would say that value investing consists of the bottom half of the barrel in terms of fundamental attraction and value multiples, except that obviously the value investor thinks that they're getting more attraction than they are paying multiples. So they get a superior bargain, but they're playing in the bottom half of the barrel. You look at Buffett, he's been a Coca-Cola holder, I think, for 50 years.

Starting point is 00:21:32 And I started in this business 52 years ago. And certainly Coca-Cola was a card carrying member of the NISTY 50, and it has always become a superior growth company. So Buffett was willing to buy and hold that for 50 years and make a ton of money. And GEICO was a growth situation. And I think he probably made more money in GEICO than any other one investment. And so why doesn't, why bar companies just because they have a lot of potential? So the value investor chooses between the Chevrolet and the Volkswagen and chooses the Volkswagen and chooses the Volkswagen because it's a lot cheaper, but has most of the features. But why not choose between Mercedes-Benz and the BMW?

Starting point is 00:22:17 Why can't you choose better value among the top half? And why can't you say that Mercedes sells for much more than the BMW, but it's worth it? Why is cheapness the requirement? And if you look at, I found it informative to look at how S&P divides the 500 into value and growth. What's their process? And for growth, it has above average growth in, let's think. I think it's above average growth in sales, above average growth in earnings, and that the stock is showing momentum.

Starting point is 00:22:55 On the other hand, what's the criteria for value? You know what it is? Low PE, low price to sales, low price to book. Not a word about fundamental merit. It assumes that those multiples cover the merit. But, I mean, a stock could have low valuation multiples because the outlook is terrible. And the methodology for populating the value index, there's nothing about that. In other words, just cheapness.

Starting point is 00:23:24 And you have to understand the difference between cheapness and value. And there's another great quote which says that, unfortunately, low price to earnings and low price to book and low price to sales will not sure you of a successful investment. And high price to book and high price to earnings and high price to sales should not be barred from your portfolio. He says that. And especially today, I think that technology is, you know, it's ubiquitous and it's great importance. And lots of low-tech companies have been sky.

Starting point is 00:24:07 studdled by technology. So just because you're not in the tech field doesn't mean you're safe because competitors can use technology against you. And I guess the greatest example is Amazon, which, you know, use technology to invade the non-tech field of bookstores. So I think that especially in the world of 2021, you can't say we ignore technology because technology is constantly changing life for all of us. You know, if you go back 40 or 50 years, we thought of the, it felt like the world was an

Starting point is 00:24:46 unchanging place. I describe it as a fixed backdrop of a stage on a play. And the play took place in front of the backdrop. That is to say, we had the economic cycles and we had the corporate developments and all that kind of thing against an unchanging backdrop. Today, the world changes every minute. So you can't say I'm an investor and I exclude from my portfolios the parts of the world that are subject to change. And once you stop saying that, you by definition get involved in growth and parts of the economy that are changing rapidly. That's one of the key conclusions of that discussion. The other

Starting point is 00:25:37 key conclusion was that it probably takes a lot of expertise to judge the faster growing companies and certainly the companies that are involved in technology and like sciences and all those kinds of things. And so you can't opine if you don't have some expertise and you shouldn't opine. And when basic businesses, basic dull businesses like newspapers and so forth were thriving and unaffected by technological competition, you could look at the market and not know much, you know, because these were simple fields to understand. And now, if you're going to get involved in the fast-growing parts of the economy like technology, you need some expertise. And you can't talk about these companies based on a superficial take. You have to get deeply involved and develop an expert view. And one of Andrew's big arguments was you can't say when the S&P was, let's say the S&P was back to 3,300.

Starting point is 00:26:42 And everybody said it doesn't make any sense that it's back to 3,300, is risen 50% from the low. And how could that be? Would the economy so soft? And by the way, the companies have PE ratios of 40 and 50. and the high tech has done so well, it's obviously out of order to have this rally. He says, how can you say that the S&P is overvalued if you can't make the case against the Fangs, for example? And in order to make the case against the Fangs, you have to have expertise.

Starting point is 00:27:12 You can't just look at a company and say, well, it's got a P.E. 50. So obviously it's overvalued because some companies can merit a P.E. of 50. So the other big part of the discussion was the undesirability of knee-jerk reactions and knee-jerk reactions to merely the absolute quantum of a PE ratio. I love the mental image of you and your son talking about this over the many months of COVID. I'm curious after all the discussions, which I'm sure are ongoing and a lot of fun. Are there any areas where you and your son still have what I'll call spirited disagreement that are. are less resolved than some of the really interesting lessons that you've laid out for us so far? The area where our views have yet to fully converge, shall I say, is cryptocurrencies.

Starting point is 00:28:01 As I said in the memo, the memo is called something of value, and I brought it out in January, and really what I was saying probably was too subtle about is the opportunity, while we were discussing value investing, what I really meant to say, the opportunity to spend months and months living with my adult son and his family was really something about and that family and friends are really a great value in life. But I mentioned in the memo that in 2017 when Bitcoin and other cryptocurrency started to invade the public consciousness, I came out in very opposed to Bitcoin. I said it's not real. There's nothing there. It's a made up concept with no ability to produce cash flow, which is the source of intrinsic value. And nothing behind.

Starting point is 00:28:47 it. And then over time, and with Andrew's discussion, first of all, I came through the realization that produces no cash flow and there's nothing behind it. That's true of so many things. It's true of art. And Andrew has said to me, well, look, Jackson Pollock painting has no intrinsic value and there's nothing behind it. But when you like to own one, they're like $80 million apiece. And there are lots of things that don't produce any cash flow that we want to own. Certainly that's true. And so the cryptocurrency guys have been picking. on gold lately, certainly true of gold. Gold produces no cash flow, and there's nothing behind gold, but gold has performed well for a few thousand years because people like gold, and they think it

Starting point is 00:29:29 has attributes that will protect value, but isn't cryptocurrency the same, just that it's the choice of a new generation. It's the better gold, the digital gold. That's their point of view. Ultimately, what about the dollar? The dollar produces no. cash flow and has exchangeable for anything. Why is the dollar desirable? Because people will accept it. Why is gold valuable? People will accept it. Paintings and diamonds. Well, Ant crypto be valuable if people accept it and aren't people accepting it increasingly all the time. That's the argument. Now, of course, the difficulty is that when you get away from what I call intrinsic value, it's hard to put a price on something.

Starting point is 00:30:18 So you don't know. How can you tell whether gold is overvalued or undervalued at 1,800 an ounce? And ditto, in the last year, or, yeah, in the last year, we've seen Bitcoin at, let's say, $7,000 and $6,000. How can you tell whether it's a buy at $7,000? And how can you tell whether it's a sale at $65,000? And, you know, the crypto or certainly the Bitcoin advocate has an argument, which is that if Bitcoin replaces X percentage of the gold supply, then it has to be Y dollars in capitalization.

Starting point is 00:30:53 And if you divide Y dollars by 21.5 million Bitcoins, which is the most that can be created under the software, you get a high price for it. So the argument has been that if Bitcoin replaces half the gold in the world, it's going to go to 500,000 per coin. Now, that's a big if. So I would say that, so Andrew, Bitcoin is now worth a good multiple of what he paid for it, even after the recent declines. So he says to me, Dad, are you willing to grant that I'm right? So what I say is I'm less convinced that you're wrong. In fact, I would say I reached the point where I can't say he's wrong. But, I mean, it's going to take a long time to see if Bitcoin or other currencies actually

Starting point is 00:31:38 find the acceptance he's talking about and get put to the uses he's talking about and consequently are worth much more than they are today. But it's hard to say he's wrong. That's an ongoing discussion. I love it. I love it. I love the entire story. It seems as though you've often used writing as a means to learn. And I'd love you to describe that process. You've written God knows how many memos on just about every interesting investing topic on the earth over decades. What have you learned about writing well and its utility? And why do you do? it so often? Well, I write the main reason I write the memos is because I love to do so. It's my creative outlet. And I'm not just a quantitative person. I'm also verbal and conceptual.

Starting point is 00:32:28 So the memos have permitted me to have the enjoyment of writing and thinking. And of course, in order to write something down, thinking has to be more concrete and clarified. Because has to stand the test. Once you've written it down, you have to be able to say, does that make sense? And the people who read it are going to find the errors in your argument. If you go back to the first memo, then you, I think it was called the route to performance and it was 1990. So what happened is that I ran into a client and he explained that he'd been managing this portfolio for 14 years and he'd never been above the 27th percentile or below the 47 percentile. That is to say he'd been solidly in the second quartile every year for 14 years in a row. And where do you think that put

Starting point is 00:33:17 him for the 14 years overall within his competitive universe, fourth percentile? In normal life, we say, well, if you range from 27 to 47, where are you on average? We have about 37. And the answer in his case was four. The reason being that in investing, most people eventually shoot themselves in the foot and that he had been able to eliminate all bottom half observations. And by being in the top half for 14 years, he was in the top decile for the whole period. And I thought that was a great realization. And then I came back to New York where one firm, one value investing firm, which was heavily in the bank stocks, had a terrible, terrible year.

Starting point is 00:33:57 And the head of it came out and said, well, you know, of course, if you want to be in the top 5%, you have to be willing to be in the bottom 5%, which I thought was diametric opposite of what the first guy had said. My reaction was my clients don't care if they're in the top 5% in a given year, and they're certainly unwilling to be in the bottom 5%. The only thing that matters is where you are for the long run. You don't get there by swinging for the fences. So it was the juxtaposition of the two events, which caused me to write that first memo. I don't think I wrote it planning to write a second one. I don't remember having a business purpose like saying I'm going to sell subscriptions or this will make me more popular.

Starting point is 00:34:36 I think I just wrote it because I thought I had something that was interesting to say to people. And that's probably why I wrote the second one a year later, which was about the pendulum between fear and greed and optimism and pessimism. And maybe that's why I wrote the third one in a couple of years later on, I think it was on the value of predictions. And the interesting thing is that I never, in the first 10 years, I never had a response. Not only did nobody ever say it was great, nobody ever said, I got it. This was in the old prehistoric days. It's as if I typed them out and printed them out on the Xerox machine and folded them and put them in envelopes and addressed them and put stamps on and threw them in the gutter

Starting point is 00:35:16 because I never had a response. But I kept doing it anyway. So the question is why, and I can't remember, frankly, Patrick, but I imagine I did it because I liked it. Would you do something that nobody else gave you any encouragement for? But then on the first day of 2000, I'd been working on a memo called bubble.com, and I brought it out on, I think it was January 3, 2000. And that proved to be correct and did so promptly, which are the two requirements. If you were correct, but it takes you five years, then nobody thinks of you as having been correct. but it was correct quickly. That's what put me on the map. And I said in, I think in the introduction to one of my books, I said that it to 10 years, I became an overnight success. I really love it. People now respond in droves, and most people say it was very helpful. And in particular, that I make complex things simple. And that makes me feel great. Now it's easy to keep going. It opens up your brain. And your brain is working at a high level, thinking these.

Starting point is 00:36:19 things through. You have to think things through very thoroughly so that you can communicate them clearly. And I'll give an example. In 06, I was writing my first memo explicitly on risk, and I think that, and the title is risk, 06. So I'm sitting there and I write down that I don't think that volatility is risk. And I think that the academics at University of Chicago, where, as you know, I attended in the late 60s for my MBA. I think the academic, Demick's picked volatility as the definition of risk for the simple reason that it's quantifiable. And it's easy to tell what a stock's volatility has been. So when you do a formula, which has a term where you have to put in volatility, you have to put in risk.

Starting point is 00:37:07 You put in volatility because it's a good way to quantify risk. The only thing is it's not risk. It's not what professional investors care about. And I've never heard anybody at Oak Tree or elsewhere say, I might buy it, but I probably won't because it could be involved. Nobody cares about volatility. What do they care about? Having unsatisfactory outcomes, losing money. But the trouble with that is the probability of an unsuccessful outcome or of losing money cannot be quantified in advance. There's no place you can look and say, well, the probability of losing money is 40%, so I'm not going to do it. There's no number.

Starting point is 00:37:45 you could guess at a number to put in, but that would not be reliable. And different grade investors would quantify the risk differently and would have different numbers. Obviously can't be factual about risk. So I wrote in that memo, a section entitled, You Can't Quantify Risk in Advance, because it's just the probability of a bad outcome. And obviously, for example, you can't quantify probability of election outcomes. We've had some tough lessons on that subject recently. You can't quantify a probability. Now, turn the page, start the next section. And for the next section, I wrote something I had never thought up before, which is that you can't quantify risk after the fact. You buy something for $100. You sell it for $200. Was it risky? And the fact that it went

Starting point is 00:38:37 from 100 to 200 tells you nothing about whether or not it was risky. So you can't know whether an investment, even a past investment was risky because risk is the probability of a bad outcome. So the question is, on the day you made the investment, was it risky or not? Was there a substantial probability of a bad outcome? And the answer is, you don't know because there's no place to look at what the probability distribution of outcomes was. You know what happened, but you don't know the other things that could have happened. And Elroy Dimson, who was a professor at the London Business School, said the greatest thing on this subject, in my opinion, he said risk means more things can happen than will happen. So if you make an investment

Starting point is 00:39:22 today, you might think it's going to produce a return of 15 percent, but obviously it could be more and it could be less. And some of the possible outcomes are severe. And, you know, and you can postulate about the probability of a bad outcome, but you can't quantify it. I mean, quantify doesn't mean put on a number. It means measure it. You can't measure the probability of bad outcome. Likewise, if you look at an investment, which is completed, you still can't quantify what the probability of a bad outcome was at the time the investment was made.

Starting point is 00:40:04 In other words, you can't quantify risk aft of the fact. And I think that's an important realization. And I never had that thought before I started writing that memo. You can't measure the probability of bad outcome. Likewise, if you look at an investment which is completed, you still can't quantify what the probability of a bad outcome was at the time the investment was made. In other words, you can't quantify risk after the fact. And I think that's an important realization.

Starting point is 00:40:35 And I never had that thought before I started writing that memo. It makes me think that one of the most important things when it comes to learning is doing, right? In your case, writing, making investments, actually doing things versus just, let's say, reading or listening. And I wonder what skills you think that's most true for in the discipline of investing. So even if you read all the things in the world about risk, are the things in your experience having worked with a lot of great investors that can't really just be read about, have to be experienced to be learned in investing? Absolutely. And because everything you'll read is what should work.

Starting point is 00:41:15 Financial analysis should work. And it works on average. It works most of the time. But nothing in investing works all the time because the environment is multivariate and changing. And we have to account for the involvement of people. But people do not behave the same every time, which makes it. very tough. And you have to learn that through experience. And you have to be able to make inferences from what's going on in your environment and deal with qualitative factors. The physicist Richard Feyneman

Starting point is 00:41:48 once said that physics would be much harder if electrons had feelings. That is to say, you know, if you turn on the light switch, the light always goes on because the electrons always flow from the light switch to the fixture. They never forget their assignment and swim in the opposite direction. They never go on strike and fail to flow or forget what they're supposed to do. They always flow in the right direction. But investing is made up of people. Markets are made up of people. Economies are made up of people. They don't always behave the way they're supposed to. They're given to psychological excesses and perversities and errors. And so I think that when you come out, understand how the market is supposed to work. If you went to Chicago, you understand that the market

Starting point is 00:42:37 is supposed to be an efficient thing that sets prices right. And if you went to school and learned financial analysis, you learned that adding X and subtracting Y should give you the right value for earnings and you apply a P.E ratio of 16 and you find the fair value. But these things don't work every time in investing. And in investing, the most important thing is to understand what's going on when they don't work. When the market is behaving as it should and is in kind of their normal value range, then things aren't too critical. But when the market gets to extremes of high and low, because of aberrant psychology and so forth, that's when you really have to know what's going on. So there's really no replacement for experience. You can read the history of the markets,

Starting point is 00:43:26 but it's hard to grasp the suicidal nature of people in October 08 or the euphoric nature of people in the second quarter of 2020. One of the things that it makes me think of is this great quote that it's easy to be brave from a safe distance. And two of your memos bear the title, Dare to be Great. I love the word dare in there. I'd love you to describe the importance of what you write about is the willingness to be wrong, willingness to be alone or different.

Starting point is 00:43:55 Why are those two things so important from the institutional level all the way down to the investor buying stocks? So what happened for the most part is that as the economy does well and companies do well and stock prices rise, become more optimistic and more confident and more greedy. And price rises relative to fundamentals. Psychology times fundamentals equals price. So given set of fundamentals, the rising psychology gives you rising price. People get more excited at the highs. They tend to buy more.

Starting point is 00:44:29 That produces further price rise, and that process continues until it can't anymore. And so most people tend to buy more at the high than they do it the low. Now, things turn down, the economy gets tired. It goes into remission, and the corporations start doing worse. The earnings reports decline, and stocks decline, and people get depressed, and now they're thinking about how much money they lost, They fear further losses and they get pessimistic and prices fall. And most people say, I can't take it anymore.

Starting point is 00:45:02 I'm afraid of further declines. I just want to get out. And so they sell on the lows. Of course, that's what make lows. High psychology makes highs. The press psychology makes lows. You should buy at lows, but of course the lows are the result of selling on the part of others. You should sell at the highs.

Starting point is 00:45:21 The highs are the result of buying by us. others. So obviously, it's important to behave at certain junctures in a contrarian way, not all the time. It's not a winning strategy to always do the opposite of what bulk of investors are doing, but at the extremes it is, and you can do it intelligently if you understand what they're doing and why and what the error is and why it's important to do the opposite. The point is that everybody says, now's the time to buy, and usually that's a high, and everybody says now is the time to sell, and usually that's a low, and everybody says this has a great outlook at the same time, which is usually synonymous with a very high price, and everybody says this thing has a terrible

Starting point is 00:46:02 outlook, and they all say it at the same time about that thing, which produces a low price. So in general, it's important to deviate from the crowd, and that's what Dare to Be Great is about. And the first memo, which I think was also maybe, you know, six, Dare to Be Great, was about, do you dare to be great? And it mainly was talking about processes and especially committee structure. I feel I'm anti-committee because I think it produces average outcomes and waters down whatever great insight any one member might have. And then I returned to the subject, I think it was in 2014, if I'm not mistaken, would dare to be great too. And there I said, you know, I've been thinking about this, the title Dare to Be Great. And the answer is everybody dares to be great. The question,

Starting point is 00:46:52 The question is, do you dare to do the things that you have to do to be great? And one of the things you have to do to be great, as I've just discussed for the last few minutes, is you have to deviate from the crowd. So a prerequisite, daring to be great is to dare to be different. Do you dare to be different? Do you dare to own things that everybody else thinks are terrible? Do you dare to not own the things that consensus agrees are fantastic and consequently are highly priced? Dave Swenson, who passed away recently, who ran the endowment at Yale with great effect for maybe 35 years. Said in his book, Pioneering Portfolio Management, that investment management requires the adoption of uncomfortably idiosyncratic positions.

Starting point is 00:47:40 You can't have a great, highly superior outcome from others if you don't do things that are different from others. by definition, if you do make the same investments as everybody else, you'll have the same performance. That's not a way to distinguish yourself. So if you want to have great outstandingly great performance, you have to do something different, idiosyncratic. By definition, it's going to be uncomfortable because everybody else thinks that X is a buy, you think it's at sale. And by the way, if they are holding it and you are selling it, chances are it'll go up for another year. So you'll look dumb for a year. And the chance of looking dumb or being terminally wrong in the end is what makes these things uncomfortable. So the question is, do you dare to be different?

Starting point is 00:48:24 There are significant consequences to being different. When I was a kid and I came into this business, the saying was you can never be fired for buying IBM because everybody buys IBM. So even if you buy it and it turns out to be a terrible investment, which you did, you can't be fired because everybody else did it. And by the way, your boss probably did it. he would have to fire himself. And remember what Kane said, it is better for reputation to fail conventionally

Starting point is 00:48:50 than to succeed unconditionally. In other words, most people can't stand to be different. So being different is very important. Do you dare to be different? And then the second question is, if you're different from the crowd,

Starting point is 00:49:03 many times it's going to fail to work. Do you dare to be wrong? Because if you are afraid of being wrong, then you have to seek out what I call the warmth of the herd. Because if you're in the middle of the herd, it's a very warm, comfortable spot. Your buddies, you're among the consensus.

Starting point is 00:49:21 Nobody can say you were more of an idiot than anybody else. But if you're in the herd, you're going to have average performance, and that's not a good thing. So the question is, do you dare to be different from the herd, which exposes you to the possibility of being wrong?

Starting point is 00:49:36 Are you willing to be wrong? And then third, are you willing to look wrong? because even people who make idiosyncratic decisions which are correct, they usually don't work right away. And so you look wrong for a while. The first of the great adages that I have learned was that it's indistinguishable. If you're too far ahead of your time, it's indistinguishable from being wrong. So even the person who dares to be different and dares to be wrong, even if it's going to work out, they're going to look wrong for a while. he dare to be look wrong for a while. And difficulty implied in all these three things, the difficulty,

Starting point is 00:50:12 how uncomfortable it is to be different, how unpleasant it is to be wrong, and how unpleasant is to look wrong for a while before being proved right. All three of those difficulties are part of the challenge of investing. As we come to the end of our conversation here, I'm realizing so much of the discussion we've used words like uncertainty and risk, but so much of it is about mystery maybe or mysteriousness. And I just wonder if you could offer some closing thoughts on the role that mystery has played in your life and career and how you've learned to embrace it and sort of what joy is embracing the mysterious can bring. Your success does not come from achieving a certain number. Your success comes from outperforming others. It's like golf. So your success comes not from how you

Starting point is 00:50:57 do in the absolute, but whether you outperform the others. And everybody wants managers and strategies and securities that will outperform. Investing is multivariate and it's competitive and it's unpredictable because of the role of people in motion, but also randomness, which is very significant. There's no randomness in engineering or dentistry. There's a lot of randomness in economics and markets. And these things make it a great challenge, but they also make it very interesting. And when I go to campus and I talk to students, I say,

Starting point is 00:51:34 if you're looking for something where you can be right every time and where the answers are absolute and concrete, then you shouldn't go into investing. But if you are interested in an intellectual challenge where there are a lot of moving pieces, many of which are not predictable, but hopefully you can get on top of them by making good judgments and understanding probabilities, then you can go into investing and greatly enjoy it. On October, the 8th,000, 8th of 08, when the world was calling for the end of the financial system, as we know it, and the meltdown of all financial institutions, it was interesting to consider whether that would happen.

Starting point is 00:52:17 And I wrote a memo shortly after the Lehman bankruptcy on September 15th entitled, now what? Will the world meltdown or not? Now, there's no place to analyze that. There's no quantification you can accomplish it. There's no equation you can solve to tell you whether the world's going to end or not. It's obviously an important question to get on top of, and you have to come up with an answer. And how do you come up with an answer?

Starting point is 00:52:40 How do you answer questions where so many things are uncertain and even where outcomes are unpredictable? But you can't be frozen in an action. You have to make an answer. And so I find it extremely rewarding to operate in this uncertain environment, but all you have to do is make better judgments than other people. You don't have to be right, but the person who makes the best judgments will have the best investment results. It's mysterious because of the insolubility of these problems and the unanswerability of the questions, but still, if you use a good approach, have good intelligence, have good expertise, in my case, have great partners and colleagues, it can be very exciting.

Starting point is 00:53:29 Well, Howard, this has been a pleasure. I remember reading a lot of your writing early in my investing career, and it was definitely a key part of the canon that helped my early education, so it's a thrill to do this with you today. I asked the same closing question of all my guests. What is the kindest thing that anyone's ever done for you? I'm lucky because I've been beneficiary,

Starting point is 00:53:48 many acts of kindness. I think that in trying to think of one concrete one, I'll take the example, and it's germane to discussion today, of the fact that in 20, 2009, I believe, I wrote a memo in which I mentioned Warren Buffett, with whom I had a nice relationship at the time. So I sent him a copy of the memo, and I said, I want to make sure you saw this. And he wrote me back. He says, you know, of course I saw it. I read it with interest.

Starting point is 00:54:19 And if you ever decide to write a book, I'll give you a blur for the jacket. So I had always been planning to turn the memos into a book when I retired, whenever that would be. But given Buffett's promise, I said, no, this is something I bet a cash now. So I wrote the most important thing over the next year. He gave me two blurbs on the front. It says, this is that rarity, a useful book. And then at the back, it says, when I see memos from Howard Marks in my inbox, they're the first thing I read.

Starting point is 00:54:51 And that goes double for this book or something like that. And the book was a huge seller. It sold well over a million copies. than half of them in China. And I always say in China, they think I am Warren Buffett. They don't understand this Buffett's writing about me. But the point is that I wouldn't have written that book at that time without Warren's encouragement. And it brought me a lot of happiness. And I think that's the most concrete example I can give you. As I say, I've been the beneficiary of many acts of kindness. Howard, thank you so much for all the insight in writing and thinking over the years.

Starting point is 00:55:25 Thank you so much for your time today. Well, thanks for your good questions and the opportunity to appear here. This episode was brought to you by Teegis. In this five-part miniseries, I sit down with Elliot Turner, the managing partner at RGA Investment Advisors, to talk about how he discovered Teegis, how Teegis helps him with his investing process, and how Teegis has made him a better investor. In this week's episode, Elliot and I discuss how using Teegis has made him a better investor and his favorite Teegis transcript. Are there ways in which Teegis opened your eyes to something that you just didn't understand before that would be a valuable part of your investing process. I think TIGIS has been incredibly helpful for me in. And I don't necessarily think this is one of the

Starting point is 00:56:07 more discussed elements of it. But in getting to read hundreds of calls that other people have done, I've learned how to think about questions better. I've learned how to structure my own calls better. I've had a clearer vision into how to build a flow starting with rapport and going through knowing which boxes I want to check along the way, but which tangents I'm willing to open myself up to. I think that's one of the more under-discussed beauties of having access to a platform like this. Is there a single transcript that stands out in memory that you read that unlocked something important for you? Oh, yeah. There was this one transcript. he was at Hitachi involved in their vendor relations platform.

Starting point is 00:56:58 And he spoke about Roku and the advantages that Roku has for someone who's manufacturing televisions. And he basically gave a list of dozens of really small little things that happened behind the scenes that even if you're intimately familiar with the product, you would not know about, even if you're intimately familiar with the value prop for a TV manufacturer, you wouldn't have realized the amount of little things they do that compound into one really large advantage from the OEM's perspective. And I think it's one of the single best expert calls I've ever read. If you enjoy this episode, check out join colossus.com.

Starting point is 00:57:38 There you'll find every episode of this podcast complete with transcripts, show notes, and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations, and more, as well as you. share the best content we find on the internet every week.

Invest Like the Best with Patrick O'Shaughnessy - Howard Marks - Embracing the Psychology of Investing - [Invest Like the Best, EP. 231]

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