The Most Important Thing Illuminated
The Most Important Thing Illuminated

The Most Important Thing Illuminated

Table of Contents

This book is about “the human side of investing.” It explores how to think and how to deal with the psychological influences that interfere with investment thinking and a lot about the mistakes others make in their thinking.

When I say “how to think,” I don’t mean to suggest that my process is the only way, just one example. You have to follow a disciplined thought process in order to be successful, but it doesn’t have to be mine. (Location 105)

Tags: investing

Note: .investing

“Experience is what you got when you didn’t get what you wanted.” (Location 151)

Tags: quote, challenges, experience

Note: .experience .challenges .quote

Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times. (Location 155)

Tags: bearmarket, challenges, investing

Note: .investing the bad times teach us good lessons

1 The Most Important Thing Is … Second-Level Thinking

Beating the market matters, but limiting risk matters just as much. Ultimately, investors have to ask themselves whether they are interested in relative or absolute returns. Losing 45 percent while the market drops 50 percent qualifies as market outperformance, but what a pyrrhic victory this would be for most of us. (Location 223)

Tags: risk, investing

Note: limiting risk is just as important as beating the market

Everyone wants to make money. All of economics is based on belief in the universality of the profit motive. So is capitalism; the profit motive makes people work harder and risk their capital. The pursuit of profit has produced much of the material progress the world has enjoyed. (Location 235)

Tags: profit, capitalism

Note: .capitalism people are driven by profit

If your behavior is conventional, you’re likely to get conventional results—either good or bad. Only if your behavior is unconventional is your performance likely to be unconventional, and only if your judgments are superior is your performance likely to be above average. (Location 314)

Tags: societal norms, average, unconventional

Note: .unconventional being conventional gets average results

The idea is that agreeing with the broad consensus, while a very comfortable place for most people to be, is not generally where above-average profits are found. (Location 329)

Tags: average, investing

Note: .investing

2 The Most Important Thing Is … Understanding Market Efficiency (and Its Limitations)

If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or nonconsensus, view. (Location 365)

Tags: unconventional, market efficiency

What about the five-star funds? you might ask. Read the small print: mutual funds are rated relative to each other. The ratings don’t say anything about their having beaten an objective standard such as a market index. (Location 386)

Tags: mutualfunds

Note: .mutualfunds mutual funds are rated relative to each other, not index markets

“The higher return is explained by hidden risk.” (Location 408)

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. (Location 409)

Tags: favorite, bullmarket, risk

Note: .risk

Let’s consider the assumptions that underlie the theory of efficient markets:   •   There are many investors hard at work. •   They are intelligent, diligent, objective, motivated and well equipped. •   They all have access to the available information, and their access is roughly equal. •   They’re all open to buying, selling or shorting (i.e., betting against) every asset.

For those reasons, theory says that all the available information will be smoothly and efficiently synthesized into prices and acted on whenever price/value discrepancies arise, so as to drive out those discrepancies. (Location 453)

Tags: market efficiency, investing

Note: .marketefficiwncy .investing

The key turning point in my investment management career came when I concluded that because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best. (Location 530)

Tags: market efficiency

3 The Most Important Thing Is … Value investor has two basic choices:

Gauge the security’s underlying intrinsic value and buy or sell when the price diverges from it

Base decisions purely on expectations regarding future price movements. (Location 570)

Tags: value investing

What is it that makes a security—or the underlying company—valuable? There are lots of candidates:

- financial resources,

- management

- factories

- retail outlets

- patents

- human resources

- brand names

- growth potential and, most of all, the ability to generate earnings and cash flow. (Location 607)

Tags: value

The difference between the two principal schools of investing can be boiled down to this:

•    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. (Location 622)

Tags: growth investing, value investing, investing, favorite

...growth stock portfolios were heavily weighted toward drugs, technology and consumer products. (Location 652)

Tags: growth investing, investing

Note: .investing

“Being too far ahead of your time is indistinguishable from being wrong.” (Location 699)

Tags: timing, quotes, favorite

There, many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated, and they like it less as the price falls, when they begin to doubt their decision to buy. This makes it very difficult to hold, and to buy more at lower prices (which investors call “averaging down”), especially if the decline proves to be extensive. If you liked it at 60, you should like it more at 50 … and much more at 40 and 30. (Location 713)

Tags: investing

Note: .investing if your stock decreases in value, in theory you should buy more

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out.

Thus, there are two essential ingredients for profit in a declining market:

you have to have a view on intrinsic value, and

you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong.

Oh yes, there’s a third: you have to be right. (Location 736)

Tags: valueinvesting

Note: .valueinvesting

4 The Most Important Thing Is … The Relationship Between Price and Value

Investment success doesn’t come from “buying good things,” but rather from “buying things well.” (Location 742)

Tags: price, value investing

Note: The price of an investment is key to determining if it is good value.

there are few assets so bad that they can’t be a good investment when bought cheap enough. (Location 749)

Tags: price

At Oaktree we say, “Well bought is half sold.” By this we mean we don’t spend a lot of time thinking about what price we’re going to be able to sell a holding for, or when, or to whom, or through what mechanism. If you’ve bought it cheap, eventually those questions will answer themselves. (Location 779)

Tags: value investing, price, investing

Note: .investing

Many value investors are not good at knowing when to sell (and many sell way too early). However, knowing when to buy cures many of the mistakes resulting from selling too early. (Location 783)

Tags: investing

Note: .investing buying cheap is half the battle

If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.

Keeping this statement in mind, that the market eventually gets it right, is one of the most important things to remember when the market acts emotionally over the short term. (Location 785)

Tags: investing

Note: .investing the market is emotional in the short term but more rational in the long term

Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge. (Location 825)

The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price, can only go one way: up. (Location 836)

Tags: invests

Note: .invests buy stock when they are unpopular

All bubbles start with some nugget of truth:   •   Tulips are beautiful and rare (in seventeenth-century Holland). •   The Internet is going to change the world. •   Real estate can keep up with inflation, and you can always live in a house.

A few clever investors figure out (or perhaps even foresee) these truths, invest in the asset, and begin to show profits. Then others catch on to the idea—or just notice that people are making money—and they buy as well, lifting the asset’s price. But as the price rises further and investors become more inflamed by the possibility of easy money, they think less and less about whether the price is fair. It’s an extreme rendition of the phenomenon I described earlier: people should like something less when its price rises, but in investing they often like it more. (Location 856)

Tags: bubble

The positives behind stocks can be genuine and still produce losses if you overpay for them. (Location 876)

Tags: price

The problem is that in bubbles, “attractive” morphs into “attractive at any price.” People often say, “It’s not cheap, but I think it’ll keep going up because of excess liquidity” (or any number of other reasons). In other words, they say, “It’s fully priced, but I think it’ll become more so.” Buying or holding on that basis is extremely chancy, but that’s what makes bubbles. (Location 890)

Tags: bubble

Of all the possible routes to investment profit, buying cheap is clearly the most reliable. (Location 927)

5 The Most Important Thing Is … Understanding Risk

Risk means more things can happen than will happen. (Location 939)

Tags: risk

Note: .risk

Surely investors who get their statements and find that their accounts made 10 percent for the year don’t know whether their money managers did a good job or a bad one. In order to reach a conclusion, they have to have some idea about how much risk their managers took. In other words, they have to have a feeling for “risk-adjusted return.” (Location 967)

Tags: invest, risk

Note: the return on an investment should be measured against the risk taken

if riskier investments reliably produced higher returns, they wouldn’t be riskier! (Location 982)

Tags: favorite, risk

Note: .risk riskier investments do not reliably return greater returns

investors who want some objective measure of risk-adjusted return—and they are many—can only look to the so-called Sharpe ratio. This is the ratio of a portfolio’s excess return (its return above the “riskless rate,” or the rate on short-term Treasury bills) to the standard deviation of the return. (Location 1133)

When markets are booming, the best results often go to those who take the most risk. (Location 1161)

Tags: bubble, trading, risk

Note: when markets are doing well the riskiest traders often do the best

The most common bell-shaped distribution is called the “normal” distribution. However, people often use the terms bell-shaped and normal interchangeably, and they’re not the same.

The former is a general type of distribution, while the latter is a specific bell-shaped distribution with very definite statistical properties. Failure to distinguish between the two doubtless made an important contribution to the recent credit crisis. (Location 1213)

Tags: normal distribution, distributions, stats

Note: .stats .distributions

Many futures are possible, to paraphrase Dimson, but only one future occurs. (Location 1231)

Tags: scenario, future

Note: .future

The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many “alternative histories” that were possible. (Location 1237)

Tags: alternative histories, favorite, investing, risk

Note: .risk .investing

Decisions whether or not to bear risk are made in contemplation of normal patterns recurring, and they do most of the time. But once in a while, something very different happens. … Occasionally, the improbable does occur. (Location 1257)

Tags: blackswan, risk

Note: .risk .blackswan

Projections tend to cluster around historic norms and call for only small changes. … people usually expect the future to be like the past and underestimate the potential for change. (Location 1259)

Tags: future, predictions

Note: .predictions people under estimate The potential for chnge in the future

in bullish times, rather than recognize risk ahead, people tend to overestimate their ability to understand how new financial inventions will work. (Location 1272)

Tags: bullmarket

6 The Most Important Thing Is … Recognizing Risk

Great investing requires both generating returns and controlling risk. (Location 1293)

Tags: risk, investing

Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do. (Location 1295)

Tags: risk

Note: .risk

Recognizing risk often starts with understanding when investors are paying it too little heed, being too optimistic and paying too much for a given asset as a result. High risk, in other words, comes primarily with high prices. (Location 1300)

Tags: price, risk

Note: high risk is mostly due to high prices

participating when prices are high rather than shying away is the main source of risk. (Location 1303)

Tags: favorite, risk

Note: .risk

Whereas the theorist thinks return and risk are two separate things, albeit correlated, the value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices. (Location 1311)

Tags: risk

Note: .risk bull markets—usually when things have been going well for a while—people tend to say, “Risk is my friend. The more risk I take, the greater my return will be. I’d like more risk, please.” (Location 1326)

Tags: bullmarket, risk

Note: when times are good people believe greater risk guarantees a greater gain

When investors are unworried and risk-tolerant, they buy stocks at high price/earnings ratios and private companies at high multiples of EBITDA (cash flow, defined as earnings before interest, taxes, depreciation and amortization), and they pile into bonds despite narrow yield spreads and into real estate at minimal “cap rates” (the ratio of net operating income to price). (Location 1335)

Tags: caprate, realestate

Note: .realestate .caprate

Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate skepticism and risk aversion. (Location 1409)

Tags: investing, price, risk

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price. (Location 1512)

Tags: risk

Note: .risk if everyone thinks something is risky the price will decrease, so it wont be very risky anymore

This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. (Location 1518)

Tags: risk

7 The Most Important Thing Is … Controlling Risk

Since it’s hard to gauge risk and risk-adjusted performance (even after the fact), and since the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard. That’s especially true in good times. (Location 1546)

Tags: risk

Note: it can be hard to gauge risk and people dont get enough credit for managing risk

...great investors are those who take risks that are less than commensurate with the returns they earn. They may produce moderate returns with low risk, or high returns with moderate risk. But achieving high returns with high risk means very little—unless you can do it for many years, in which case that perceived “high risk” either wasn’t really high or was exceptionally well managed. (Location 1549)

Tags: risk

Note: .risk

Likewise, loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment. (Location 1560)

Tags: favorite, risk

Note: .risk

When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest. (Location 1615)

Tags: risk

Note: .risk

How can life insurance companies—some of the most conservative companies in America—insure people’s lives when they know they’re all going to die? ... It’s risk they can diversify.

By ensuring a mix of policyholders by age, gender, occupation and location, they make sure they’re not exposed to freak occurrences and widespread losses. (Location 1618)

Tags: insurance

Risk control is not risk avoidance, and the “right price” is the operative part of his statement. (Location 1690)

8 The Most Important Thing Is … Being Attentive to Cycles

"You Can’t Predict. You Can Prepare,” borrowing the advertising tagline of MassMutual Life Insurance Company because I agree wholeheartedly with their theme: we never know what lies ahead, but we can prepare for the possibilities and reduce their sting. (Location 1716)

Tags: prepare

Note: .prepare

1 - most things will prove to be cyclical. 2 - some of the greatest opportunities for gain and loss come when other people forget rule number one. (Location 1721)

“the worst loans are made at the best of times.” (Location 1757)

Tags: bubble, lending, loans

Note: .loans .lending we take more risks in good times

9 The Most Important Thing Is … Awareness of the Pendulum

Very early in my career, a veteran investor told me about the three stages of a bull market. Now I’ll share them with you.   •   The first, when a few forward-looking people begin to believe things will get better •   The second, when most investors realize improvement is actually taking place •   The third, when everyone concludes things will get better forever... (Location 1921)

Tags: bullmarket

Note: .bullmarket

Stocks are cheapest when everything looks grim. (Location 1930)

Tags: price

It is hard for the average investor to commit capital to a new investment when the outlook is gloomy. Yet it is precisely in these moments that potential returns are at their highest. (Location 1933)

...the three stages of a bear market:   •    The first, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy •    The second, when most investors recognize things are deteriorating •    The third, when everyone’s convinced things can only get worse... (Location 1953)

Tags: bearmarket

Note: .bearmarket

For a bullish phase … to hold sway, the environment has to be characterized by greed, optimism, exuberance, confidence, credulity, daring, risk tolerance and aggressiveness. But these traits will not govern a market forever. Eventually they will give way to fear, pessimism, prudence, uncertainty, skepticism, caution, risk aversion and reticence. … Busts are the product of booms, and I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction. (Location 2001)

Tags: bubble, bullmarket

10 The Most Important Thing Is … Combating Negative Influences

It can be enormously challenging to remain objective and calculating in the face of facts like these:   •   Investment results are evaluated and compared in the short run. •   Incorrect, even imprudent, decisions to bear increased risk generally lead to the best returns in good times (and most times are good times). •   The best returns bring the greatest ego rewards. When things go right, it’s fun to feel smart and have others agree. (Location 2137)

A strong sense of intrinsic value is the only way to withstand the psychological influences that affect behavior. Those who can’t value companies or securities have no business investing and limited prospects (other than luck) for investing successfully. This sounds simple, but plenty of investors lack it. (Location 2271)

Tags: value investing

11 The Most Important Thing Is … Contrarianism

“Once-in-a-lifetime” market extremes seem to occur once every decade or so—not often enough for an investor to build a career around capitalizing on them. But attempting to do so should be an important component of any investor’s approach. (Location 2331)

Markets can be over- or underpriced and stay that way—or become more so—for years. (Location 2363)

The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain. (Location 2500)

12 The Most Important Thing Is … Finding Bargains

The process of intelligently building a portfolio consists of buying the best investments, making room for them by selling lesser ones, and staying clear of the worst. 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. (Location 2514)

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. (Location 2622)

Since bargains provide value at unreasonably low prices—and thus unusual ratios of return to risk—they represent the Holy Grail for investors. (Location 2677)

13 The Most Important Thing Is … Patient Opportunism

When prices are high, it’s inescapable that prospective returns are low (and risks are high). (Location 2796)

Tags: price

14 The Most Important Thing Is … Knowing What You Don’t Know

the important thing in forecasting isn’t getting it right once. The important thing is getting it right consistently. (Location 2952)

Tags: planning, forecasting

Note: .forecasting

One way to get to be right sometimes is to always be bullish or always be bearish; if you hold a fixed view long enough, you may be right sooner or later. And if you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value. (Location 2958)

Once in a while, however, the future turns out to be very different from the past. •   It’s at these times that accurate forecasts would be of great value. •   It’s also at these times that forecasts are least likely to be correct. •   Some forecasters may turn out to be correct at these pivotal moments, suggesting that it’s possible to correctly forecast key events, but it’s unlikely to be the same people consistently. •   The sum of this discussion suggests that, on balance, forecasts are of very little value. (Location 2980)

Tags: forecasts

Note: .forecasts market forecasts are generaly useless

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” (Location 3071)

Tags: risk

15 The Most Important Thing Is … Having a Sense for Where We Stand

Market cycles present the investor with a daunting challenge, given that:   •   Their ups and downs are inevitable. •   They will profoundly influence our performance as investors. •   They are unpredictable as to extent and, especially, timing. (Location 3078)

Tags: marketcycles

Note: .marketcycles

“Those who cannot remember the past are condemned to repeat it.” (Location 3118)

Tags: history

Note: .history

When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into inaction or panic selling, we should become aggressive. (Location 3125)

16 The Most Important Thing Is … Appreciating the Role of Luck

in boom times, the highest returns often go to those who take the most risk. That doesn’t say anything about their being the best investors. (Location 3287)

Tags: bubble, luck

The correctness of a decision can’t be judged from the outcome. Nevertheless, that’s how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa. (Location 3316)

Tags: favorite, decisions

Note: .decisions

the quality of a decision is not determined by the outcome. The events that transpire afterward make decisions successful or unsuccessful, and those events are often well beyond anticipating. (Location 3337)

17 The Most Important Thing Is … Investing Defensively

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. (Location 3508)

The prudent lender’s reward comes only in bad times, in the form of reduced credit losses. The lender who insists on margin for error won’t enjoy the highest highs but will also avoid the lowest lows. That’s what happens to those who emphasize defense. (Location 3577)

18 The Most Important Thing Is … Avoiding Pitfalls

An investor needs do very few things right as long as he avoids big mistakes. (Location 3704)

Tags: avoid mistakes

In my book, trying to avoid losses is more important than striving for great investment successes. The latter can be achieved some of the time, but the occasional failures may be crippling. (Location 3709)

Tags: avoid mistakes

Many of the psychological or emotional sources of error were discussed in previous chapters: greed and fear; willingness to suspend disbelief and skepticism; ego and envy; the drive to pursue high returns through risk bearing; and the tendency to overrate one’s foreknowledge. These things contribute to booms and busts, in which most investors join together to do exactly the wrong thing. (Location 3726)

It’s worth noting that the assumption that something can’t happen has the potential to make it happen, since people who believe it can’t happen will engage in risky behavior and thus alter the environment.

Twenty or more years ago, the term mortgage lending was associated inextricably with the word conservative. Home buyers put down 20 to 30 percent of the purchase price; mortgage payments were limited to 25 percent of monthly income by tradition; houses were appraised carefully; and borrowers’ income and financial position had to be documented. But when the appetite for mortgage-backed securities rose in the past decade—in part because mortgages had always performed so dependably and it was agreed there couldn’t be a nationwide surge in mortgage defaults—many of these traditional norms went out the window. The consequences shouldn’t have come as a surprise. (Location 3769)

Tags: risk, mortgage

Note: if people believe something cant happen it may make it more likely to occur as people take bigger risks

Widespread disregard for risk creates great risk. “Nothing can go wrong.” “No price is too high.” “Someone will always pay me more for it.” “If I don’t move quickly, someone else will buy it.” Statements like these indicate that risk is being given short shrift. This cycle’s version saw people think that because they were buying better companies or financing with more borrower-friendly debt, buyout transactions could support larger and larger amounts of leverage. (Location 3866)

Tags: risk

Note: .risk disregard for risk causes greater risk

19 The Most Important Thing Is … Adding Value

The Most Important Thing Is … Reasonable Expectations

21 The Most Important Thing Is … Pulling It All Together

Most trends—both bullish and bearish—eventually become overdone, profiting those who recognize them early but penalizing the last to join. That’s the reasoning behind my number one investment adage: “What the wise man does in the beginning, the fool does in the end.” The ability to resist excesses is rare, but it’s an important attribute of the most successful investors. (Location 4281)