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The Most Important Thing Illuminated Uncommon Sense for the Thoughtful Investor by Howard Marks

The Most Important Thing Illuminated Uncommon Sense for the Thoughtful Investor by Howard Marks

[Leo] Deep & solid base sharing, information for value investors. Howard also highlighted & proposed some of the ideas, which I consider, highly practical for practitioners such as: differences between probability & risk, the highest risk of all is risk of loss (all) – also not every time higher risk = higher return, it always has some “unhistory” element can happen.

The skilful investor is the one who gains a bit more on the up-side, and loses a bit less on the down-side, and we need to manage our expectations. If things are too good to be true, we need to rethink.

Manage risk, control loss, reasonable expectations, be prudent, be aware (awake?), always be careful, do not overconfident, appreciate the role of luck in our life, the unhappened incidents/possibilities – superiority takes time.

“if we avoid the losers, the winners will take care of themselves.”

— Quote from the Book — 

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To me, risk is the most interesting, challenging and essential aspect of investing.

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Importantly, a philosophy like mine comes from going through life with your eyes open. You must be aware of what’s taking place in the world and of what results those events lead to. Only in this way can you put the lessons to work when similar circumstances materialize again. Failing to do this—more than anything else—is what dooms most investors to being victimized repeatedly by cycles of boom and bust.

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I’m convinced that no idea can be any better than the action taken on it, and that’s especially true in the world of investing.

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What is second-level thinking?

  • First-level thinking says, “It’s a good company; let’s buy the stock.”

Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”

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The bottom line for me is that, although the more efficient markets often misvalue assets, it’s not easy for any one person— working with the same information as everyone else and subject to the same psychological influences—to consistently hold views that are different from the consensus and closer to being correct.

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Once in a while we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise.

Those halcyon periods lull people into believing that to get higher returns, all they have to do is make riskier investments. But they ignore something that is easily forgotten in good times: this can’t be true, because if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.

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His first test is always the same: “And who doesn’t know that?”

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Human beings are not clinical computing machines. Rather, most people are driven by greed, fear, envy and other emotions that render objectivity impossible and open the door for significant mistakes.

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Some investors can consistently outperform others. Because of the existence of (a) significant misvaluations and (b) differences among participants in terms of skill, insight and information access, it is possible for misvaluations to be identified and profited from with regularity.

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For every person who gets a good buy in an inefficient market, someone else sells too cheap. One of the great sayings about poker is that “in every game there’s a fish. If you’ve played for 45 minutes and haven’t figured out who the fish is, then it’s you.” The same is certainly true of inefficient market investing.

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The great debate over efficiency versus inefficiency, I have concluded that no market is completely one or the other. It’s just a matter of degree.

I wholeheartedly appreciate the opportunities that inefficiency can provide

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  • Why should a bargain exist despite the presence of thousands of investors who stand ready and willing to bid up the price of anything that’s too cheap?
  • If the return appears so generous in proportion to the risk, might you be overlooking some hidden risk?
  • Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?
  • Do you really know more about the asset than the seller does?
  • If it’s such a great proposition, why hasn’t someone else snapped it up?

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The random walk hypothesis says a stock’s past price movements are of absolutely no help in predicting future movements. In other words, it’s a random process, like tossing a coin. We all know that even if a coin has heads ten times in a row, the probability of heads on the next throw is still fifty-fifty.

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Value investors buy stocks (even those whose intrinsic value may show little growth in the future) out of conviction that the current value is high relative to the current price.

  • Growth investors buy stocks (even those whose current value is low relative to their current price) because they believe the value will grow fast enough in the future to produce substantial appreciation.

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In general, the upside potential for being right about growth is more dramatic, and the upside potential for being right about value is more consistent. Value is my approach. In my book, consistency trumps drama.

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For a value investor, price has to be the starting point. It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.

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People should like something less when its price rises, but in investing they often like it more.

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Here the problem is that using leverage—buying with borrowed money—doesn’t make anything a better investment or increase the probability of gains. It merely magnifies whatever gains or losses may materialize.

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But riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple: if riskier investments reliably produced higher returns, they wouldn’t be riskier!

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The traditional risk/return graph (figure 5.1) is deceptive because it communicates the positive connection between risk and return but fails to suggest the uncertainty involved. It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money.

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It’s meant to suggest both the positive relationship between risk and expected return and the fact that uncertainty about the return and the possibility of loss increase as risk increases.

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The possibility of permanent loss is the risk I worry about

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Mostly it comes down to psychology that’s too positive and thus prices that are too high. Investors tend to associate exciting stories and pizzazz with high potential returns. They also expect high returns from things that have been doing well lately

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The bottom line is that, looked at prospectively, much of risk is subjective, hidden and unquantifiable.

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Skillful investors can get a sense for the risk present in a given situation. They make that judgment primarily based on (a) the stability and dependability of value and (b) the relationship between price and value. Other things will enter into their thinking, but most will be subsumed under these two while it says nothing explicitly about the likelihood of loss

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Because of its latent, nonquantitative and subjective nature, the risk of an investment—defined as the likelihood of loss—can’t be measured in retrospect any more than it can a priori.

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Understanding uncertainty: The possibility of a variety of outcomes means we mustn’t think of the future in terms of a single result but rather as a range of possibilities. The best we can do is fashion a probability distribution that summarizes the possibilities and describes their relative likelihood. We must think about the full range, not just the ones that are most likely to materialize. Some of the greatest losses arise when investors ignore the improbable possibilities.

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“There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.”

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Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.

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The riskiest things: The greatest risk doesn’t come from low quality or high volatility. It comes from paying prices that are too high. This isn’t a theoretical risk; it’s very real.

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There are few things as risky as the widespread belief that there’s no risk, because it’s only when investors are suitably risk-averse that prospective returns will incorporate appropriate risk premiums.

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Like opportunities to make money, the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions. Regardless of what’s designed into market structures, risk will be low only if investors behave prudently.

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Risk cannot be eliminated; it just gets transferred and spread. And developments that make the world look less risky usually are illusory, and thus in presenting a rosy picture they tend to make the world more risky.

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Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion.

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Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion. Contributing underlying factors can include low prospective returns on safer investments, recent good performance by risky ones, strong inflows of capital, and easy availability of credit.

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market line of the sort that has become familiar to many of us, as shown in figure 6.1.

Figure 6.1

A big problem for investment returns today stems from the starting point for this process: The riskless rate isn’t 4 percent; it’s closer to 1 percent….

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The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.

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But high quality assets can be risky, and low quality assets can be safe.It’s just a matter of the price paid for them. … Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.

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Risk—the possibility of loss—is not observable. What is observable is loss, and loss generally happens only when risk collides with negative events.

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Here the manager’s value added comes not through higher return at a given risk, but through reduced risk at a given return.

This, too, is a good job—maybe even a better one.

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Controlling the risk in your portfolio is a very important and worthwhile pursuit. The fruits, however, come only in the form of losses that don’t happen. Such what-if calculations are difficult in placid times.

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We invest only when we’re convinced the likely return far more than compensates for the risk.

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It’s by bearing risk when we’re well paid to do so—and especially by taking risks toward which others are averse in the extreme—that we strive to add value for our clients.

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Skillful risk control is the mark of the superior investor.

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In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and “sure things” can fail. However, there are two concepts we can hold to with confidence:

  • Rule number one: most things will prove to be cyclical.
  • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

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Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on.

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This belief that cyclicality has ended exemplifies a way of thinking based on the dangerous premise that “this time it’s different.”

These four words should strike fear—and perhaps suggest an opportunity for profit—for anyone who understands the past and knows it repeats. Thus, it’s essential that you be able to recognize this form of error when it arises.

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The riskiest things: When things are going well, extrapolation introduces great risk. Whether it’s company profitability, capital availability, price gains, or market liquidity, things that inevitably are bound to regress toward the mean are often counted on to improve forever.

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Risk aversion is the essential ingredient in a rational market, as I said before, 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.

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In my opinion, the greed/fear cycle is caused by changing attitudes toward risk.

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When investors in general are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-averse, prices can offer more return than risk.

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One of these days, though, we’ll reach the third stage, and the herd will give up on there being a solution. And unless the financial world really does end, we’re likely to encounter the investment opportunities of a lifetime. Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.

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Demosthenes: “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.”

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Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense. It happens so regularly that there must be something dependable at work, not a random influence.

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In my view, the road to investment success is usually marked by humility, not ego.

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  • a promise to remember that when things seem “too good to be true,” they usually are,

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Rather, the trend, the consensus view, is something to game against, and the consensus portfolio is one to diverge from. As the pendulum swings or the market goes through its cycles, the key to ultimate success lies in doing the opposite.

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You must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong.

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If everyone likes it, it’s probably because it has been doing well. Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has been borrowed from the future and thus presages subpar performance from here on out.

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Superior investors know—and buy—when the price of something is lower than it should be. And the price of an investment can be lower than it should be only when most people don’t see its merit.

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Skepticism is what it takes to look behind a balance sheet, the latest miracle of financial engineering or the can’t-miss story. … Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t. The best investors I know exemplify this trait. It’s an absolute necessity.

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Sometimes skepticism requires us to say, “no, that’s too bad to be true.”

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It’s our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling —and if our view turns out to be right—that’s the route to the greatest rewards earned with the least risk.

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The raw materials for the process consist of (a) a list of potential investments, (b) estimates of their intrinsic value, (c) a sense for how their prices compare with their intrinsic value, and (d) an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.

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Investment is the discipline of relative selection.

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In general, that means price is low relative to value, and potential return is high relative to risk. How do bargains get that way?

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Our goal is to find underpriced assets. Where should we look for them? A good place to start is among things that are:

  • little known and not fully understood;
  • fundamentally questionable on the surface;
  • controversial, unseemly or scary;
  • deemed inappropriate for “respectable” portfolios;
  • unappreciated, unpopular and unloved;
  • trailing a record of poor returns; and • recently the subject of disinvestment, not accumulation.

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To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality.

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Investment bargains needn’t have anything to do with high quality. In fact, things tend to be cheaper if low quality has scared people away.

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Patient opportunism—waiting for bargains—is often your best strategy.

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So here’s a tip: You’ll do better if you wait for investments to come to you rather than go chasing after them.

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All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.

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Others disappeared because they insisted on pursuing high returns in low-return environments.

You simply cannot create investment opportunities when they’re not there. The dumbest thing you can do is to insist on perpetuating high returns—and give back your profits in the process. If it’s not there, hoping won’t make it so.

When prices are high, it’s inescapable that prospective returns are low (and risks are high).

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My “research” on this subject (and I use quotation marks because my efforts in the area are too limited and anecdotal to be considered serious research) has consisted primarily of reading forecasts and observing their lack of utility.

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There’s a third possibility, however, and in my opinion it’s the right one by a wide margin. Why not simply try to figure out where we stand in terms of each cycle and what that implies for our actions?

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We may never know where we’re going, but we’d better have a good idea where we are. That is, even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.

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In more skeptical times, investors take a dim view of combining leverage and cyclicality.

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It turned out that risk hadn’t been banished and, in fact, had been elevated by investors’ excessive trust and insufficient skepticism.

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To fully explore the notion of luck, in this chapter I want to advance some ideas expressed by Nassim Nicholas Taleb in his book Fooled by Randomness. Some of the concepts I explore here occurred to me before I read it, but Taleb’s book put it all together for me and added more. I consider it one of the most important books an investor can read

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the fact that a stratagem or action worked—under the circumstances that unfolded—doesn’t necessarily prove the decision behind it was wise.

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The sub optimizers of the “I don’t know” school, on the other hand, put their emphasis on constructing portfolios that will do well in the scenarios they consider likely and not too poorly in the rest.

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  • We have to practice defensive investing, since many of the outcomes are likely to go against us. It’s more important to ensure survival under negative outcomes than it is to guarantee maximum returns under favorable ones.

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Several things go together for those who view the world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly; insistence on defensive investing; and emphasis on avoiding pitfalls.

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“Which do you care about more, making money or avoiding losses?” 

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Oaktree portfolios are set up to outperform in bad times, and that’s when we think outperformance is essential. Clearly, if we can keep up in good times and outperform in bad times, we’ll have above-average results over full cycles with below-average volatility, and our clients will enjoy outperformance when others are suffering.

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But what’s defense? Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.

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There’s no right answer, just trade-offs.

That’s why I added this concluding thought in December 2007:

“Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in the good times, investors must choose between the two.”

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At Oaktree, on the other hand, we believe firmly that “if we avoid the losers, the winners will take care of themselves.”

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Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high-quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing does go wrong, surely the winners will take care of themselves.

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In my book, trying to avoid losses is more important than striving for great investment successes.

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So the general rule is that it’s important to avoid pitfalls, but there must be a limit. And the limit is different for each investor.

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The third form of error doesn’t consist of doing the wrong thing, but rather of failing to do the right thing.

Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them. Most investors would hope to not buy, or perhaps even to sell, when greed has driven a stock’s price too high. But superior investors might sell it short in order to profit when the price falls. Committing the third form of error—e.g., failing to short an overvalued stock—is a different kind of mistake, an error of omission, but probably one most investors would be willing to live with.

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  • Leverage magnifies outcomes but doesn’t add value. It can make great sense to use leverage to increase your investment in assets at bargain prices offering high promised returns or generous risk premiums. But it can be dangerous to use leverage to buy more of assets that offer low returns or narrow risk spreads—in other words, assets that are fully priced or overpriced. It makes little sense to use leverage to try to turn inadequate returns into adequate returns.

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While it was nigh onto impossible to avoid declines completely, relative outperformance in the form of smaller losses was enough to let you do better in the decline and take greater advantage of the rebound.

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When there’s nothing particularly clever to do, the potential pitfall lies in insisting on being clever.

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In the good years the average is good enough.

There is a time, however, when we consider it essential to beat the market, and that’s in the bad years. Our clients don’t expect to bear the full brunt of market losses when they occur, and neither do we.

Thus, it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious.

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—it’s reasonable to aspire to returns in single digits or perhaps low double digits.

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There’s just one antidote: asking whether the result you’re expecting is too good to be true. This requires the application of skepticism, a quality that’s absolutely essential for investment success.

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“I checked it out, and it makes sense.”

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In addition to “Is it too good to be true,” just ask “Why me?” When the salesman on the phone offers you a guaranteed route to profit, you should wonder what made him offer it to you rather than hog it for himself.

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That leaves buying on the way down, which we should be glad to do.

The good news is that if we buy while the price is collapsing, that fact alone often causes others to hide behind the excuse that “it’s not our job to catch falling knives.” After all, it’s when knives are falling that the greatest bargains are available.

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If we think something is cheap, we buy. If it gets cheaper, we buy more. And if we commit all our capital, we assume we’ll be able to raise more.

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I encourage you to think about “good-enough returns.” It’s essential to realize that there are returns so high that they aren’t worth going for and risks that aren’t worth taking.

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The superior investor never forgets that the goal is to find good buys, not good assets.

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Buying based on strong value, low price relative to value, and depressed general psychology is likely to provide the best results. Even then, however, things can go against us for a long time before turning as we think they should. Underpriced is far from synonymous with going up soon. Thus the importance of my second key adage: “Being too far ahead of your time is indistinguishable from being wrong.” It can require patience and fortitude to hold positions long enough to be proved right.

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go well beyond the academics’ singular definition of risk as volatility and understand that the risk that matters most is the risk of permanent loss.

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Most investors think diversification consists of holding many different things; few understand that diversification is effective only if portfolio holdings can be counted on to respond differently to a given development in the environment.

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Oaktree’s motto, “If we avoid the losers, the winners will take care of themselves,” has served well over the years. A diversified portfolio of investments, each of which is unlikely to produce significant loss, is a good start toward investment success.

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Risk control lies at the core of defensive investing. Rather than just trying to do the right thing, the defensive investor places a heavy emphasis on not doing the wrong thing.

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Risk control and margin for error should be present in your portfolio at all times. But you must remember that they’re “hidden assets.” Most years in the markets are good years, but it’s only in the bad years—when the tide goes out—that the value of defense becomes evident. Thus, in the good years, defensive investors have to be content with the knowledge that their gains, although perhaps less than maximal, were achieved with risk protection in place … even though it turned out not to be needed.

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The more micro your focus, the greater the likelihood you can learn things others don’t.

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In both economic forecasting and investment management, it’s worth noting that there’s usually someone who gets it exactly right … but it’s rarely the same person twice. The most successful investors get things “about right” most of the time, and that’s much better than the rest.

Leo.

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