pankaj pawar's Key Ideas from The Most Important Thing
by Howard Marks

• Second-level thinking
• Understanding market efficiency(and its limitations)
• Value
• The relationship between price and value
• understanding risk
• recognizing risk 
• controlling risk 
• being attentive to cycles
• awareness of the pendulum
• combating negative influences
• contrarianism
• Finding bargains
• pateint opportunism 
• knowing what you dont know 
• having sense for where we stand 
• appreciating the role of luck
• investing defensively 
• Avoiding pitfalls
• adding value 

Few people have what it takes to be a great investors. some can be taught, but not everyone... and those who can be taught can't be taught everything.

No rule always works.

one of the most important things to bear in mind today is that economics isn't and exact science. it may not even be much of a science at all,in the sense that in science, controlled experiments can be conducted, past results can be replicated with confidence, and cause-and effect relationships can be depended on to hold.

"One of the things i most want to emphasize is how essential it is that one's investment approach be intuitive and adaptive rather than be fixed and mechanistic."

"The defitnition of successful investing is doing better than market and other investors"

"The defitnition of successful investing is doing better than market and other investors" and to accomplish that you need either good luck or superior insights.

Remember your goal in investing isn't to earn average returns; you want to do better than average. Thus, your thinking has to be better than others

• First-level thinking says, "it's a good company; lets 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 or overpriced; let's sell.
• First-level thinking says, "The outlook calls for low growth and rising inflation. Let's dump our stocks." Second-Level-thinking says, "The outlook stinks,but everyone else is selling in panic. Buy!"
• First=level-thinking says, "I think the company's earnings will fall; sell."

Second-level thinking says, "I think the company's earnings will fall less than people expect, and the pleasant surprise will lift the stock; Buy."

First-level-thinking is simplistic and superficial; and just about everyone can do it(a bad sign for anything involving an attempt at superiority.) All the first-level thinker needs is an opinion about the future, as in " The outlook for the company is favorable, meaning the stock will go up".

Second-Level Thinker take a great many things into account:

1. What is the range of likely future outcome?
2. Which outcome do i think will occur?
3. What's the probability I'm right?
4. What does the consensus think?
5. How does my expectation differ from the concensus?
6. How does the current price for the asset comporr with the consensus view of the future, and with mine?
7. Is the consensus psychology that's incorporated in the price too bullish or bearish?
8. What will happen to the asset's price if the consensus turns out be right, and what if i'm right?

First level thinkers look for simple formulas and easy answers, second level thinkers know that success in investing is the antithesis of simple. "Brokerage firms want you to think everyone's capable of investing-- at 10$ per trade. Mutual fund companies don't want you tp think you can do it; they want youto think they can do it. In the case, you'll put your money into actively managed funds and pay associated high fees.

If your behaviour is conventional, you're likely to get conventional results- either good or bad. Only if your behaviour is unconventional is your performance likely to be unconventional, and only if your judgements are superior is your performance likely to be above average--- "DARE TO BE GREAT", SEPTEMBER 7,2006

The upshot is simple: To achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That's not easy. 

The attractiveness of buying something for less than it’s worth makes eminent sense. So how is one to find bargains in efficient markets? You must bring exceptional analytical ability, insight or foresight. But because it’s exceptional, few people have it.“Returns and How They Get That Way,” November 11, 2002"

Those who consider the investment process simple generally aren’t aware of the need for— or even the existence of—second- level thinking. 

Thus, many people are misled into believing that everyone can be a successful investor. Not everyone can. But the good news is that the prevalence of first- level thinkers increases the returns available to second- level thinkers. To consistently achieve superior investment returns, you must be one of them.

.

The theory included concepts that went on to become important elements in investment dialogue: risk aversion, volatility as the definition of risk, risk- adjusted returns, systematic and nonsystematic risk, alpha, beta, the random walk hypothesis and the effi cient market hypothesis. 

• There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed.
• Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.

• If prices inefficient markets already refl ect 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.
• 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 infl uences— to consistently hold views that are different from the consensus and closer to being correct. Th at’s what makes the mainstream markets hard to beat— even if they aren’t always right.

The most important upshot from the efficient market hypothesis is its conclusion that “you can’t beat the market.” 

One of the greatest ramifi cations of the Chicago theory has been the development of passive investment vehicles known as index funds.

According to investment theory, people are risk-averse by nature, meaning that in general they’d rather bear less risk than more.For them to make riskier investments, they have to be induced through the promise of higher returns.

“The higher return is explained by hidden risk.” 

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.

In fact, some asset classes are quite efficient. In most of these:

• the asset class is widely known and has a broad following;

• the class is socially acceptable, not controversial or taboo;

• the merits of the class are clear and comprehensible, at least on the surface; and

• information about the class and its components is distributed widely and evenly.

If these conditions are met, there’s no reason why the asset class should systematically be overlooked, misunderstood or underrated

Second- level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both. They are on the alert for instances of misperception. second- level thinkers depend on inefficiency. 

Where might errors come from? Let’s consider the assumptions that underlie the theory of efficient markets:

• 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 every asset

A market characterized by mistakes and mispricings can be beaten by people with rare insight. Thus, the existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it. It does not, however, guarantee it.

To me, an ineffi cient market is one that is marked by at least one of the following characteristics: 

• Market prices are often wrong. Because access to information 

and the analysis thereof are highly imperfect, market prices are 

often far above or far below intrinsic values.

• The risk- adjusted return on one asset class can be far out of line with those of other asset classes. Because assets are often valued at other- than- fair prices, an asset class can deliver a risk- adjusted return that is significantly too high (a free lunch) or too low relative to other asset classes.

• Some investors can consistently outperform others. coz of the existence of

(a) significant misvaluations 

(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.

Inefficient markets do not necessarily give their participants generous returns. Rather, it’s my view that they provide the raw material— mispricings—that can allow some people to win and others to lose on the basis of differential skill. If prices can be very wrong, that means it’s possible to fi nd bargains or overpay.

 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 fi gured out who the fish is, then it’s you.” The same is certainly true of inefficient market investing.

Think of it this way:

• 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?

Something else to keep in mind: just because efficiencies exist today doesn’t mean they’ll remain forever.Bottom line: Inefficiency is a necessary condition for superior investing. Attempting to outperform in a perfectly effi cient market is like flipping a fair coin: the best you can hope for is fifty- fifty. For investors to get an edge, there have to be ineffi ciencies in the underlying process— imperfections, mispricings— to take advantage of.

The image here is 

of the efficient- market- believing fi nance professor who takes a walk with a student.

“Isn’t that a $10 bill lying on the ground?” asks the student.

“No, it can’t be a $10 bill,” answers the professor. “If it were, 

someone would have picked it up by now.”

The professor walks away, and the student picks it up and has 

a beer.

Th e oldest rule in investing is also the simplest: “Buy low; sell high.”

 obvious— on the surface: it means that you 

should buy something at a low price and sell it at a high price. But what, in turn, does that mean? What’s high, and what’s low?

On a superficial level, you can take it to mean that the goal is to buy something for less than you sell it for.

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 pro cess, like tossing a coin. We all know that even if a coin has come up heads ten times in a row, the probability of heads on the next throw is still fifty- fifty.Like￾wise, the hypothesis says, the fact that a stock’s price has risen for the last ten days tells you nothing about what it will do tomorrow.

Another form of relying on past stock price movements to tell you something is so- called momentum investing. It, too, exists in contravention of the random walk hypothesis. I’m unlikely to do it justice. But as I see it, investors who practice this approach operate under the assumption that they can tell when something that has been rising will continue to rise.

Momentum investing might enable you to participate in a bull market that continues upward, but I see a lot of drawbacks. One is based on econo￾mist Herb Stein’s wry observation that “if something cannot go on forever, it will stop.” What happens to momentum investors then? How will this approach help them sell in time to avoid a decline? And what will it have them do in falling markets?

The way I see it, day traders considered themselves successful if they bought a stock at $10 and sold at $11, bought it back the next week at $24 and sold at $25, and bought it a week later at $39 and sold at $40. If you can’t see the fl aw in this— that the trader made $3 in a stock that appreciated by $30.

 value investing and growth investing. In a nutshell, value investors aim to come up with a security’s current intrinsic value and buy when the price is lower, and growth investors try to find securities whose value will increase rapidly in the future.

To value investors, an asset isn’t an ephemeral concept you invest in because you think it’s attractive. It’s a tangible object that should have an intrinsic value 

capable of being ascertained, and if it can be bought below its 

intrinsic value, you might consider doing so. Thus, intelligent investing has to be built on estimates of intrinsic value. Th ose esti￾mates must be derived rigorously, based on all of the available information.

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.

 The emphasis in value investing is on tangible factors like hard assets and cash flows.Intangibles like talent, popular fashions and long- term growth potential are given less weight. 

There’s even something called “net- net investing,” in which people buy when the total market value of a company’s stock is less than the amount by which the company’s current assets— such as cash, receivables and inventories— exceed its total liabilities.In this case, in theory, you could buy all the stock, liquidate the current assets, pay off the debts, and end up with the business and some cash. Pocket cash equal to your cost, and with more left over you’ll have paid “less than nothing” for the business.

value investing and growth investing. In a nutshell, value investors aim to come up with a security’s current intrinsic value and buy when the price is lower, and growth investors try to find securities whose value will increase rapidly in the future.

intelligent investing has to be built on estimates of intrinsic value. Th ose estimates must be derived rigorously, based on all of the available information.

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. 

• 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. Thus, it seems to me, the choice isn’t really between value and growth, but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.Compared to value investing, growth investing centers around trying for big winners. 

Let’s say you fi gure out that something’s worth 80 and have a chance to buy it for 60. Chances to buy well below actual value don’t come along every day, and you should welcome them. Warren Buffett describes them as “buying dollars for fifty cents.” So you buy it and you feel you’ve done a good thing.

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 diffi cult 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. 

An accurate opinion on valuation, loosely held, will be of limited help. An incorrect opinion on valuation, strongly held, is far worse. Th is one statement shows how hard it is to get it all right.

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 profi t 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.

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

Let’s say you’ve become convinced of the efficacy of value investing and you’re able to come up with an estimate of intrinsic value for a stock or other asset. Let’s even say your estimate is right. You’re not done. In order to know what action to take, you have to look at the asset’s price relative to its value. Establishing a healthy relationship between fundamentals— value—and price is at the core of successful investing.

When people say flatly, “we only buy A” or “A is a superior asset class,” that sounds a lot like “we’d buy A at any price . . . and we’d buy it before B, C or D at any price.” That just has to be a mistake. No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.

Bottom line: there’s no such thing as a good or bad idea regardless of price!

What are the companies worth? Eventually, this is what it comes down to. It’s not enough to buy a share in a good idea, or even a good business. You must buy it at a reasonable (or, hopefully, a bargain) price.

• You can’t make a career out of buying from forced sellers and selling to forced buyers; they’re not around all the time, just on rare occasions at the extremes of crises and bubbles.
• Since buying from a forced seller is the best thing in our world, being a forced seller is the worst. This requires both long- term capital and strong psychological resources.

Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity.

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.

• The positives behind stocks can be genuine and still produce losses if you overpay for them.
• “Prices are too high” is far from synonymous with “the next move will be downward.” Things can be overpriced and stay that way for a long time . . . or become far more so.
• Eventually, though, valuation has to matter.

• Benefiting from a rise in the asset’s intrinsic value.
• Applying leverage.
• Selling for more than your asset’s worth.
• Buying something for less than its value.

Risk means more things can happen than will happen.

                                                                          ---ELROY DIMSON

Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.

The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it. Because the issue is so complex and so important, I devote three chapters to examining risk in depth.

people are naturally risk- averse, meaning they’d rather take less risk than more. 

Especially in good times, far too many people can be overheard saying, “Riskier investments provide higher returns. If you want to make more money, the answer is to take more risk.” 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!

There are many kinds of risk. . . . But volatility may be the least relevant of them all. Theory says investors demand more return from investments that are more volatile. 

• Falling short of one’s goal—
• Underperformance—
• Career risk— 
• Unconventionality—
• Illiquidity—

Theory says high return is associated with high risk because the former exists to compensate for the latter. But pragmatic value investors feel just the opposite: They believe high return and low risk can be achieved simultaneously by buying things for less than they’re worth. In the same way, overpaying implies both low return and high risk.

Given the difficulty of quantifying the probability of loss, 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. This calculation seems serviceable for public market securities that trade and price often; there is some logic, and it truly is the best we have.

• Risk exists only in the future, and it’s impossible to know for sure what the future holds. 
• Decisions whether or not to bear risk are made in contemplation of normal patterns recurring, and they do most of the time. 
• Projections tend to cluster around historic norms and call for only small changes. 
• We hear a lot about “worst- case” projections, but they often turn out not to be negative enough.
• Risk shows up lumpily.
• People overestimate their ability to gauge risk and understand mechanisms they’ve never before seen in operation. 
• most people view risk taking primarily as a way to make money

• story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away. 

Invariably things can get worse than people expect. 

My belief is that because the system is now more stable, we’ll make it less stable through more leverage, more risk taking.    

                                                                                        MYRON SCHOLES

Great investing requires both generating returns and controlling risk. And recognizing risk is an absolute prerequisite for controlling it.Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do. The next important step is to describe the process through which risk can be recognized for what it is.

Recognizing risk oft en 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. participating when prices are high rather than shying away is the main source of risk.

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).

 “Jill Fredston is a nationally recognized avalanche expert. . . She knows about a kind of moral hazard risk, where better safety gear can entice climbers to take more risk— making them in fact less safe.” 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.Th e bottom line is that tales like this one about risk control 

rarely turn out to be true. Risk cannot be eliminated

The risk- is- gone myth is one of the most dangerous sources of risk, and a major contributor to any bubble. At the extreme of the pendulum’s upswing, the belief that risk is low and that the investment in question is sure to produce profi ts intoxicates the herd and causes its members to forget caution, worry and fear of loss, and instead to obsess about the risk of missing opportunity.

Worry and its relatives, distrust, skepticism and risk aversion, are essential ingredients in a safe financial system.

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

• 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
• And, of course, as demonstrated by the experience of Nift y Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. No risk is feared, and thus no reward for risk bearing— no “risk premium”— is demanded or provided. That can make the thing that’s most esteemed the riskiest

Outstanding investors, in my opinion, are distinguished at least as much for their ability to control risk as they are for generating return.

What ever few awards are presented for risk control, they’re never given out in good times. Th e reason is that risk is covert, invisible. Risk— the possibility of loss— is not observable. What is observable is loss, and loss generally happens only when risk collides with negative events.

Germs cause illness, but germs themselves are not illness. We might say illness is what results when germs take hold.

The important thing here is the realization that risk may have been present even though loss didn’t occur. Th erefore, the absence of loss does not necessarily mean the portfolio was safely constructed.Reality is far more vicious than Russian roulette.

First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. Aft er a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security. . . . Second, unlike a well- defi ned precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. . . . One is thus capable of unwittingly playing Rus sian roulette— and calling it by some alternative “low risk” name...

I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.

• 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.

The basic reason for the cyclicality in our world is the involvement of humans. Mechanical things can go in a straight line. Time moves ahead continuously. So can a machine when it’s adequately powered. But processes in fi elds like history and economics involve people, and when people are involved, the results are variable and cyclical. Th e main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

• The economy moves into a period of prosperity.

• Providers of capital thrive, increasing their capital base.

• Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.

• Risk averseness disappears.

• Financial institutions move to expand their businesses— that is, to provide more capital.

• They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction and easing covenants.

• Losses cause lenders to become discouraged and shy away.

• Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.

• Less capital is made available— and at the trough of the cycle, only to the most qualifi ed of borrowers, if anyone.

• Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.

• This pro cess contributes to and reinforces the economic contraction.

We conclude that most of the time, the future will look a lot like the past, with both up cycles and down cycles. 

When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.

• between euphoria and depression,

• between celebrating positive developments and obsessing over negatives, and thus

• between overpriced and underpriced.

This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.”

• 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

Why would anyone waste time trying for a better description? This one says it all. It’s essential that we grasp its significance.The market has a mind of its own, and it’s changes in valuation parameters, caused primarily by changes in investor psychology, that account for most short- term changes in security prices. Th is psychology, too, moves like a pendulum.

The oscillation of the investor pendulum is very similar in nature to the up- and- down fluctuation of economic and market cycles.

• In theory with regard to polarities such as fear and greed, the pendulum 

should reside mostly at a midpoint between the extremes. But it doesn’t for long.

• Primarily because of the workings of investor psychology, it’s usually swinging toward or back from one extreme or the other.

• The pendulum cannot continue to swing toward an extreme, or reside at an extreme, forever (although when it’s positioned at its greatest extreme, people increasingly describe that as having become a permanent condition).

• Like a pendulum, the swing of investor psychology toward an extreme causes energy to build up that eventually will contribute to the swing back in the other direction. Sometimes, the pent- up energy is itself the cause of the swing back— that is, the pendulum’s swing toward an extreme corrects of its very weight.

• The swing back from the extreme is usually more rapid— and thus takes much less time— than the swing to the extreme. (Or as my partner Sheldon Stone likes to say, “The air goes out of the balloon much faster than it went in.”)

The occurrence of this pendulum- like pattern in most market phenomena is extremely dependable. But just like the oscillation of cycles, we never know:

• how far the pendulum will swing in its arc,

• what might cause the swing to stop and turn back,

• when this reversal will occur, or

• how far it will then swing in the opposite direction.

The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing— these factors are near universal. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, widespread and recurring.

in this chapter howard marks talk about the 6 negative influences that effect the dicision making ability of an investor.

• Greed
• Fear
• Suspension of disbelied 
• Conformism 
• Envy 
• Ego 
• Capitulation 

There’s only one way to describe most investors: trend followers. Superior investors are the exact opposite. Superior investing, as I hope I’ve convinced you by now, requires second- level thinking a way of thinking that’s different from that of others, more complex and more insightful. By definition, most of the crowd can’t share it. Thus, the judgments of the crowd can’t hold the key to success. Rather, trend, consensus view, is something to game against, and the consensus portfolio is one to diverge from.just do the opposite.

warren buffett is urging us to do the opposite of what others do: to be contrarians.

• Markets swing dramatically, from bullish to bearish and from overpriced to underpriced.

• Their movements are driven by the actions of “the crowd,” “the herd” or “most people.” Bull markets occur because more people want to buy than sell, or the buyers are more highly motivated than the sellers. The market rises as people switch from being sellers to being buyers, and as buyers become even more motivated and the sellers less so. (If buyers didn’t predominate, the market wouldn’t be rising.)

•  Market extremes represent infl ection points. Th ese occur when bullishness or bearishness reaches a maximum. Figuratively speaking, a top occurs when the last person who will become a buyer does so. Since every buyer has joined the bullish herd by the time the top is reached, bullish￾ness can go no further and the market is as high as it can go. Buying or holding is dangerous.

• Since there’s no one left to turn bullish, the market stops going up. And if on the next day one person switches from buyer to seller, it will start to go down.

• So at the extremes, which are created by what “most people” believe, most people are wrong.

• Therefore, the key to investment success has to lie in doing the opposite: in diverging from the crowd. Th ose who recognize the errors that others make can profi t enormously through contrarianism.

“Buy low; sell high” is the time- honored dictum, but inves￾tors who are swept up in market cycles too oft en do just the opposite. Th e proper response lies in contrarian behavior: buy when they hate ’em, and sell when they love ’em. “Once- in- a-lifetime” 

• Contrarianism isn’t an approach that will make you money all of the time. Much of the time there aren’t great market excesses to bet against.

• Even when an excess does develop, it’s important to remember that “overpriced” is incredibly diff erent from “going down tomorrow.”

• Markets can be over- or underpriced and stay that way— or become more so— for years.

• It can be extremely painful when the trend is going against you.

• It can appear at times that “everyone” has reached the conclusion that the herd is wrong. What I mean is that contrarianism itself can appear to have become too pop u lar, and thus contrarianism can be mistaken for herd behavior.

• Finally, it’s not enough to bet against the crowd. Given the diffi culties associated with contrarianism just mentioned, the potentially profi table recognition of divergences from consensus thinking must be based on reason and analysis. 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. Only then will you be able to hold fi rmly to your views and perhaps buy more as your positions take on the appearance of mistakes and as losses accrue rather than gains.

The best opportunities are usually found among things most others won’t do.

Th e 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. Th e raw materials for the pro cess 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,

(d) an understanding of the risks involved in each, and of the eff ect their inclusion would have on the portfolio being assembled.

More often they create a list of investment candidates meeting their minimum criteria, and from those they choose the best bargains. 

an investor might start by narrowing the list of possibili￾ties to those whose riskiness falls within acceptable limits, since there can be risks with which certain investors aren’t comfortable. Examples might include the risk of obsolescence in a fast- moving segment of the technology world, and the risk that a hot consumer product will lose its popularity; these might be subjects that some investors consider beyond their expertise.

Thus, it’s not what you buy; it’s what you pay 

for it. A high- quality asset can constitute a good or bad buy, and a low quality asset can constitute a good or bad buy. Th e tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, get most investors into trouble.

• Unlike assets that become the subject of manias, potential bargains usually display some objective defect. An asset class may have weaknesses, a company may be a laggard in its industry, a balance sheet may be over- levered, or a security may afford its holders inadequate structural protection.
• Unlike market darlings, the orphan asset is ignored or scorned. To the extent it’s mentioned at all by the media and at cocktail parties, it’s in unflattering terms.

• Since the efficient-market pro cess of setting fair prices requires the involvement of people who are analytical and objective, bargains usually are based on irrationality or incomplete understanding. Thus, bargains are often created when investors either fail to consider an asset fairly, or fail to look beneath the surface to understand it thoroughly, or fail to overcome some non- value- based tradition, bias or stricture.
• Usually its price has been falling, making the first- level thinker ask, “Who would want to own that?”

• As a result, a bargain asset tends to be one that’s highly unpopular. Capital stays away from it or flees, and no one can think of a reason to own it.

• Little known and not fully understood;

• Fundamentally questionable on the surface;

• Controversial, unseemly or scary;

• Deemed inappropriate for “respectable” portfolios;

• unappreciated, unpop u lar and unloved;

• Trailing a record of poor returns; and

• recently the subject of disinvestment, not accumulation.

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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. You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own. An opportunist buys things because they’re offered at bargain prices. There’s nothing special about buying when prices aren’t low

Among the values prized in early Japanese culture was mujo. 

Mujo was defined classically for me as recognition of “the turning of the wheel of the law,” implying acceptance of the inevitability of change, of rise and fall. . . . In other words, mujo means cycles will rise and fall, things will come and go, and our environment will change in ways beyond our control. Th us we must recognize, accept, cope and respond. Isn’t that the essence of investing?

. . . What’s past is past and can’t be undone

In Berkshire Hathaway’s 1997 Annual Report, Buff ett talked about Ted Williams— the “Splendid Splinter”— one of the greatest hitters in history. A factor that contributed to his success was his intensive study of his own game. By breaking down the strike zone into 77 baseball- sized “cells” and charting his results at the plate, he learned that his batting average was much better when he went after only pitches in his “sweet spot.” Of course, even with that knowledge, he couldn’t wait all day for the perfect pitch; if he let three strikes go by without swinging, he’d be called out.

• The more we concentrate on smaller- picture things, the more it’s possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Thus, I suggest people try to “know the knowable.”
• Investors should make an effort to figure out where they stand at a moment in time in terms of cycles and pendulums. That won’t render the future twists and turns knowable, but it can help one prepare for likely developments.

• Most of the time, people predict a future that is a lot like the recent past.

• They’re not necessarily wrong: most of the time the future largely is a rerun of the recent past.

• On the basis of these two points, it’s possible to conclude that forecasts will prove accurate much of the time: Th ey’ll usually extrapolate recent experience and be right.

• However, the many forecasts that correctly extrapolate past experience are of little value. Just as forecasters usually assume a future that’s a lot like the past, so do markets, which usually price in a continuation of recent history. Th us if the future turns out to be like the past, it’s unlikely big money will be made, even by those who foresaw correctly that it would.
• 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.

• They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success.

• They’re confident it can be achieved.

• They know they can do it.

• They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.

• They’re comfortable investing based on their opinions regarding the future.

• They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.

• They rarely look back to rigorously assess their record as forecasters.

Confident is the key word for describing members of this school. 

For the “I don’t know” school, on the other hand, the 

word—especially when dealing with the macro- futureis 

guarded.Its adherents generally believe you can’t know the 

 future; you don’t have to know the future; and the proper goal 

is to do the best possible job of investing in the absence of that 

knowledge

Join the “I don’t know” school and the results are more mixed. You’ll soon tire of saying “I don’t know” to friends and strangers alike. Aft er a while, even relatives will stop asking where you think the market’s going. You’ll never get to enjoy that one- in a-thousand moment when your forecast comes true and the Wall Street Journal runs your picture. On the other hand, you’ll be spared all those times when forecasts miss the mark, as well as the losses that can result from investing based on overrated knowledge of the future.

Oh yes; the biggest problems tend to arise when investors forget about the difference between probability and outcome—that is, when they forget about the limits on foreknowledge:

• when they believe the shape of the probability distribution is knowable with certainty (and that they know it),

• when they assume the most likely outcome is the one that will happen,

• when they assume the expected result accurately represents the actual result, or

• perhaps most important, when they ignore the possibility of improbable outcomes.

Imprudent investors who overlook these limitations tend to make mistakes.

One key question investors should ask is whether they view the future as knowable or unknowable. if they feel they know what the future holds will act assertively: making directional bets, concentrating positions, leveraging holdings, and counting on future growth –doing things that, in the absence of foreknowledge, would increase risk. and, those who feel they don't know what the future holds will act differently: diversifying, hedging, leveraging less , emphasizing value today over growth tomorrow, staying high in the capital structure,and generally girding for a variety of possible outcomes

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• Their ups and downs are inevitable.

• They will profoundly influence our performance as investors.

• They are unpredictable as to extent and, especially, timing.

Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill.

The investment world is not an orderly and logical place where the future can be predicted and specifi c actions always produce specifi c results. The truth is, much in investing is ruled by luck. Some may prefer to call it chance or randomness, and those words do sound more sophisticated than luck. 

• Investors are right (and wrong) all the time for the “wrong reason.” Someone buys a stock because he or she expects a certain development; it doesn’t occur; the market takes the stock up anyway; the investor looks good (and invariably accepts credit).

• 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.

• Thus, it’s essential to have a large number of observations— lots of years of data— before judging a given manager’s ability

Taleb’s idea of “alternative histories”— the other things that reasonably could have happened— is a fascinating concept, and one that is particu￾larly relevant to investing.

Since the investors of the “I know” school, described in chapter 14, feel it’s possible to know the future, they decide what it will look like, build portfolios designed to maximize returns under that one scenario, and largely disre￾gard the other possibilities. Th e suboptimizers 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.

• We should spend our time trying to fi nd value among the knowable— industries, companies and securities— rather than base our decisions on what we expect from the less- knowable macro world of economies and broad market per for mance.

• Given that we don’t know exactly which future will obtain, we have to get value on our side by having a strongly held, analytically derived opinion of it and buying for less when opportunities to do so present themselves.

• 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.

• To improve our chances of success, we have to emphasize acting contrary to the herd when it’s at extremes, being aggressive when the mar￾ket is low and cautious when it’s high.

• Given the highly indeterminate nature of outcomes, we must view strategies and their results— both good and bad— with suspicion until proved out over a large number of trials.

There are old investors, and there are bold investors, but there are no old bold investors.

When friends ask me for personal investment advice, my fi rst step is to try to understand their attitude toward risk and return. Asking for investment advice without specifying that is like asking a doctor for a good medicine without telling him or her what ails you.So I ask, “Which do you care about more, making money or avoiding losses?” The answer is invariably the same: both.Th e best way to put this decision into perspective is by thinking of it in terms of offense versus defense. And one of the best ways to consider this is through the meta phor of sports.

But the tennis the rest of us play is a “loser’s game,” with the match going to the player who hits the fewest losers. The winner just keeps the ball in play until the loser hits it into the net or off the court. In other words, in amateur tennis, points aren’t won; they’re lost. I recognized in Ramo’s loss- avoidance strategy the version of tennis I try to play.

Charley Ellis took Ramo’s idea a step further, applying it to investments. His views on market efficiency and the high cost of trading led him to conclude that the pursuit of winners in the mainstream stock markets is unlikely to pay off for the investor. Instead, you should try to avoid hitting losers. I found this view of investing absolutely compelling.

Defensive investing sounds very erudite, but I can simplify it: Invest scared! Worry about the possibility of loss.

• The first is the exclusion of losers from portfolios. 
• The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes. 

Concentration (the opposite of diversifi cation) and leverage are two examples of offense.

 Defense, on the other hand, can increase your likelihood of being able to get through the tough times and survive long enough to enjoy the eventual payoff from smart investments.

The critical element in defensive investing is what Warren Buffett calls “margin of safety” or “margin for error.” 

Here’s a way to illustrate margin for error. You find something you think will be worth $100. If you buy it for $90, you have a good chance of gain, as well as a moderate chance of loss in case your assumptions turn out to be too optimistic. But if you buy it for $70 instead of $90, your chance of loss is less. That $20 reduction provides additional room to be wrong and still come out okay. Low price is the ultimate source of margin for error.

So the choice is simple: try to maximize returns through aggressive tactics, or build in protection through margin for error. You can’t have both in full mea sure. Will it be offense, defense or a mix of the two (and, if so, in what proportions)? Of the two ways to perform as an investor— racking up exceptional gains and avoiding losses— I believe the latter is the more dependable. A conscious balance must be struck between striving for return and limiting risk— between offense and defense. 

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

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In many ways, psychological forces are some of the most interesting sources of investment error. They can greatly influence security prices.

How are investors harmed by these forces?

• By succumbing to them.

• By participating unknowingly in markets that have been distorted by others’ succumbing.

• By failing to take advantage when those distortions are present.

• Too much capital availability makes money flow to the wrong places.
• When capital goes where it shouldn’t, bad things happen. 
• When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error.When people want to buy something, their competition takes the form of an auction in which they bid higher and higher. 
•  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.”
• Inadequate due diligence leads to investment losses.

• In heady times, capital is devoted to innovative investments, many of which fail the test of time. 
• Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. 
• Psychological and technical factors can swamp fundamentals
• Markets change, invalidating models.
• Leverage magnifies outcomes but doesn’t add value. 
•  Excesses correct. When investor psychology is extremely rosy and markets are “priced for perfection”— based on an assumption that things will always be good— the scene is set for capital destruction.

• data or calculation error in the analytical pro cess leads to incorrect appraisal of value;

• the full range of possibilities or their consequences is underestimated;

• greed, fear, envy, ego, suspension of disbelief, conformity or capitulation, or some combination of these, moves to an extreme;

• as a result, either risk taking or risk avoidance becomes excessive;

• prices diverge signifi cantly from value; and

• investors fail to notice this divergence, and perhaps contribute to its furtherance.

• not buying,

• not buying enough,

• not making one more bid in an auction,

• holding too much cash,

• not using enough leverage, or

• not taking enough risk.

• buying too much,

• buying too aggressively,

• making one bid too many,

• using too much leverage, and

• taking too much risk in the pursuit of superior returns.

When investor psychology is at equilibrium and fear and greed are balanced, asset prices are likely to be fair relative to value.

The performance of investors who add value is asymmetrical. The percentage of the market’s gain they capture is higher than the percentage of loss they suffer. . . . Only skill can be counted on to add more in propitious environments than it costs in hostile ones. This is the investment asymmetry we seek.

It’s not hard to perform in line with the market in terms of risk and return. The trick is to do better than the market: to add value.

• One is beta, a measure of a portfolio’s relative sensitivity to market movements.
• The other is alpha, which I define as personal investment skill, or the ability to perform that is unrelated to movement of the market.

portfolio with a beta above 1 is expected to be more volatile than the market, and a beta below 1 means it’ll be less volatile.Multiply the market return by the beta and you’ll get the return that a given portfolio should be expected to achieve, omitting nonsystematic sources of risk.If the market is up 15 percent, a portfolio with a beta of 1.2 should return 18 %.

  y = α + βx

Here α is the symbol for alpha, β stands for beta, and x is the return of the market. Th e market- related return of the portfolio is equal to its beta times the market return, and alpha (skill- related return) is added to arrive at the total return (of course, theory says there’s no such thing as alpha).

Although I dismiss the identity between risk and volatility, I insist on considering a portfolio’s return in the light of its overall riskiness, as discussed earlier. A manager who earned 18 percent with a risky portfolio isn’t necessarily superior to one who earned 15 percent with a lower- risk portfolio. Risk- adjusted return holds the key, even though— since risk other than volatility can’t be quantifi ed— I feel it is best assessed judgmentally, not calculated scientifically.

Of course, I also dismiss the idea that the alpha term in the equation has to be zero. Investment skill exists, even though not everyone has it. Only through thinking about risk- adjusted return might we determine whether an investor possesses superior insight, investment skill or alpha . . . that is, whether the investor adds value.

In good years in the market, it’s good enough to be average. Everyone makes money in the good years, and I have yet to hear anyone explain convincingly why it’s important to beat the market when the market does well. No, in the good years 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.

In order to stay up with the market when it does well, a portfolio has to incorporate good mea sures of beta and correlation with the market. But if we’re aided by beta and correlation on the way up, shouldn’t they be  expected to hurt us on the way down?

If we’re consistently able to decline less when the market declines and also participate fully when the market rises, this can be attributable to only one thing: alpha, or skill.

That’s an example of value- added investing, and if demonstrated over a period of decades, it has to come from investment skill.