Howard Marks: Lessons from a Crisis

Widespread disregard for risk creates great risk. “Nothing can 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. This caused them to ignore the risk of untoward developments and the danger inherent in highly leveraged capital structures.

Inadequate due diligence leads to investment losses. The best defense against is thorough, insightful analysis and insistence on what Warren Buffett calls “margin of error.” But in hot markets, people worry about missing out, not about losing money, and time-consuming, skeptical analysis becomes of the province of old fogeys.

In heady times, capital is devoted to innovative investments, many of which fail the test of time. Bullish investors focus on what might work, not what might go wrong. Eagerness takes over from prudence, causing people to accept new investment products they don’t understand. Later, they wonder what they could have been thinking.

Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. It’s easier to assess the return and risk of an investment than to understand how it will move relative to others. Correlation is often underestimated, especially because of the degree to which it increases in crisis. A portfolio may appear to be diversified as to asset class, industry and geography, but in tough times, nonfundamental factors such as margin calls, frozen markets and a general rise in risk aversion  can become dominant, affecting everything similarly.

Psychological and technical factors can swamp fundamentals. In the long run, value creation and destruction are driven by fundamentals such as economic trends, companies’ earnings, demand for products and the skillfulness of management. But in the short run, markets are highly responsive to investor psychology and the technical factors that influence the supply and demand for assets. In fact, I think confidence matters more than anything else in the short run. Anything can happen in this regard, with results that are both unpredictable and irrational.

Markets change, invalidating models. Accounts of the difficulties of “quant” funds center on the failure of computer models and their underlying assumptions. The computers that run portfolios attempt primarily to profit from patterns that held true in past markets. They can’t predict changes in those patterns; they can’t anticipate aberrant periods; and thus they generally overestimate the reliability of past norms.

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

Excesses correct. When investor psychology is extremely rosy and markets are “priced to perfection” — based on an assumption that things will always be good — the scene is set for capital destruction. It may happen because investors’ assumptions turn out to be too optimistic, because negative events occur, or simply because too-high prices collapse of their weight.

Most of these eleven lessons can be reduced to just one: be alert to what’s going on around you with regard to the supply/demand balance for investable funds and the eagerness to spend them.