The art of investment has one characteristic that is not generally appreciated. A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to imrove this easily attainable standard requires much application and more than a trace of wisdom

"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

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.”

Index funds and risk

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

In theory there’s no diff erence between theory and practice, but in practice there is.

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.

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.

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.

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.

“Chicago School Theory”

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

Everything should be made simple as possible, but not simpler

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"

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.

The most important thing is...second-level thinking

• 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.

<ul><li class="ql-align-justify">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.</li><li class="ql-align-justify">Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.</li></ul>

Efficient market hypothesis

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".

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.

<ul><li class="ql-align-justify">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.</li><li class="ql-align-justify">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!"</li><li class="ql-align-justify">First=level-thinking says, "I think the company's earnings will fall; sell."</li></ul>

What is second level thinking?

<ul><li class="ql-align-justify">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.</li><li class="ql-align-justify">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.</li></ul>

Consensus and non-consensus view

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"

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

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 Most Important Thing Is . . . Value

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

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.

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 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.

Day traders

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.

Value vs growth investing

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.

Value investing

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?

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.

Net-Net investing

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

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.

The random walk 
hypothesis

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.

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.

Believer vs Non believers of EMH

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?

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.

Second-Level Thinker take a great many things into account:<ol><li class="ql-align-justify">What is the range of likely future outcome?</li><li class="ql-align-justify">Which outcome do i think will occur?</li><li class="ql-align-justify">What's the probability I'm right?</li><li class="ql-align-justify">What does the consensus think?</li><li class="ql-align-justify">How does my expectation differ from the concensus?</li><li class="ql-align-justify">How does the current price for the asset comporr with the consensus view of the future, and with mine?</li><li class="ql-align-justify">Is the consensus psychology that's incorporated in the price too bullish or bearish?</li><li class="ql-align-justify">What will happen to the asset's price if the consensus turns out be right, and what if i'm right?</li></ol>

It's not supposed to be easy, anyone who finds it easy is stupid.

"This is that rarity, a useful book."--Warren Buffett Howard Marks, the chairman and cofounder of Oaktree Capital Management, is renowned for his insightful assessments of market opportunity and risk. After four decades spent ascending to the top of the investment management profession, he is today sought out by the world's leading value investors, and his client memos brim with insightful commentary and a time-tested, fundamental philosophy. Now for the first time, all readers can benefit from Marks's wisdom, concentrated into a single volume that speaks to both the amateur and seasoned investor. Informed by a lifetime of experience and study, The Most Important Thing explains the keys to successful investment and the pitfalls that can destroy capital or ruin a career. Utilizing passages from his memos to illustrate his ideas, Marks teaches by example, detailing the development of an investment philosophy that fully acknowledges the complexities of investing and the perils of the financial world. Brilliantly applying insight to today's volatile markets, Marks offers a volume that is part memoir, part creed, with a number of broad takeaways. Marks expounds on such concepts as "second-level thinking," the price/value relationship, patient opportunism, and defensive investing. Frankly and honestly assessing his own decisions--and occasional missteps--he provides valuable lessons for critical thinking, risk assessment, and investment strategy. Encouraging investors to be "contrarian," Marks wisely judges market cycles and achieves returns through aggressive yet measured action. Which element is the most essential? Successful investing requires thoughtful attention to many separate aspects, and each of Marks's subjects proves to be the most important thing.

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Howard Marks (born Dennis Howard Marks) was a Welsh author, former teacher and drug smuggler who achieved notoriety as an international cannabis smuggler through high-profile court cases, supposed connections with groups such as the CIA, the IRA, MI6, and the Mafia, and his eventual conviction at the hands of the American Drug Enforcement Administration. At the height of his drug career, he was said to have controlled 10% of the world's hashish trade.Marks attended Balliol College, Oxford between 1964 and 1967 to study Natural Science, with a Physics (B.A., Oxon).

CHARLIE MUNGER

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