The Most Important Thing – Howard Marks

Successful investing requires thoughtful attention to many separate aspects, all at the same time. Omit any one and the result is likely to be less than satisfactory.

Just a way to think that might help you make good decisions and, perhaps more important, avoid the pitfalls that ensnare so many.

victimized repeatedly by cycles of boom and bust.

“Experience is what you got when you didn’t get what you wanted.”

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.

1994 spike in interest rates that put rate-sensitive debt instruments into freefall; the

Some of the most important for me were Charley Ellis’s great article “The Loser’s Game” (The Financial Analysts Journal, July-August 1975), A Short History of Financial Euphoria, by John Kenneth Galbraith (New York: Viking, 1990) and Nassim Nicholas Taleb’s Fooled by Randomness (New York: Texere, 2001). Each did a great deal to shape my thinking.

John Kenneth Galbraith on human foibles;

Bruce Newberg on “probability and outcome”; Michael Milken on conscious risk bearing; and Ric Kayne on setting “traps” (underrated investment opportunities where you can make a lot but can’t lose a lot).

In fact, 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.

Beating the market matters, but limiting risk matters just as much.

In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You must be more right than others . . . which by definition means your thinking has to be different.

What is the range of likely future outcomes? Which outcome do I think will occur? What’s the probability I’m right? What does the consensus think? How does my expectation differ from the consensus? How does the current price for the asset comport with the consensus view of the future, and with mine?

Is the consensus psychology that’s incorporated in the price too bullish or bearish? What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

and only if your judgments are superior is your performance likely to be above average.

You must bring exceptional analytical ability, insight or foresight. But because it’s exceptional, few people have it.

Different and better: that’s a pretty good description of second-level thinking.

I agree that because investors work hard to evaluate every new piece of information, asset prices immediately reflect the consensus view of the information’s significance. I do not, however, believe the consensus view is necessarily correct.

They realize that nothing—and certainly not the indiscriminate acceptance of risk—carries the promise of a free lunch, and they’re reminded of the limitations of investment

theory.

What are the things that determine the movements of one currency versus another? Future growth rates and inflation rates.

how often will stocks become mispriced, and how regularly can any one person detect those mispricings? Answer: Not often, and not dependably. But that is the essence of second-level thinking.

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.

and I believe strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there.

“rebuttable presumption”—something that should be presumed to be true until someone proves otherwise.

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?

Many of the best bargains at any point in time are found among the things other investors can’t or won’t do.

Theory informed that decision and prevented me from wasting my time in the mainstream markets, but it took an understanding of the limits of the theory to keep me from completely accepting the arguments against active management.

“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.

For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.

This estimate of value includes an estimate for future growth in earnings or cash flow.

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.

are valuable precisely because they can translate eventually into earnings and cash flow.

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.

That’s because in the world of investing, being correct about something isn’t at all synonymous with being proved correct right away.

Ideally, considerably less. The bigger the discount, the bigger your margin of safety. Too small a discount and the limited margin of safety provides no real protection at all.

“Being too far ahead of your time is indistinguishable from being wrong.”

Investors with no knowledge of (or concern for) profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time.

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

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.

Since buying from a forced seller is the best thing in our world, being a forced seller is the worst.

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

When you pay for perfection, you don’t get what you expected,

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.

control over emotion and ego

The polar opposite of conscientious value investing is mindlessly chasing bubbles, in which the relationship between price and value is totally ignored.

The positives behind stocks can be genuine and still produce losses if you overpay for them. Those positives—and the massive profits that seemingly everyone else is enjoying—can eventually cause those who have resisted participating to capitulate and buy. A “top” in a stock, group or market occurs when the last holdout who will become a buyer does so. The timing is often unrelated to fundamental developments. “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. The problem is that increases in value are hard to predict accurately. Further, the conventional view of the potential for increase is usually baked into the asset’s price, meaning that unless your view is different from the consensus and superior, it’s likely you’re already paying for the potential improvement. In certain areas of investing—most notably private equity (the buying of

companies) and real estate—“control investors” can strive to create increases in value through active management of the asset. This is worth doing, but it’s time-consuming and uncertain and requires considerable expeartise. And it can be hard to bring about improvement, for example, in an already good company. Applying leverage. Here the problem is that using leverage—buying with borrowed money—doesn’t make anything a better investment or increase the probability of gains. It merely magnifies whatever gains or losses may materialize.And it introduces the risk of ruin if a portfolio fails to satisfy a contractual value test and lenders can demand their money back at a time when prices and illiquidity are depressed. Over the years leverage has been associated with high returns, but also with the most spectacular meltdowns and crashes.

Selling for more than your asset’s worth. Everyone hopes a buyer will come along who’s willing to overpay for what they have for sale. But certainly the hoped-for arrival of this sucker can’t be counted on. Unlike having an underpriced asset move to its fair value, expecting appreciation

on the part of a fairly priced or overpriced asset requires irrationality on the part of buyers that absolutely cannot be considered dependable. Buying something for less than its value. In my opinion, this is what it’s all about—the most dependable way to make money. Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality. When the market’s functioning properly, value exerts a magnetic pull on price.

John Maynard Keynes pointed out, “The market can remain irrational longer than you can remain solvent.”

In order to reach a conclusion, they have to have some idea about how much risk their managers took.

The correct formulation is that in order to attract capital, riskier investments have to offer the prospect of higher returns, or higher promised returns, or higher expected returns. But there’s absolutely nothing to say those higher prospective returns have to materialize.

Riskier investments are those for which the outcome is less certain. That is, the probability distribution of returns is wider. When priced fairly, riskier investments should entail: higher expected returns, the possibility of lower returns, and in some cases the possibility of losses.

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

According to the academicians who developed capital market theory, risk equals volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition of risk.

Rather than volatility, I think people decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return.

The possibility of permanent loss is the risk I worry about, Oaktree worries about and every practical investor I know worries about.

Thus, for this investor, risk isn’t just losing money or volatility, or any of the above. It’s being unable when needed to turn an investment into cash at a reasonable price. This, too, is a personal risk.

but their performance is generally excellent on average, more consistent than that of “hot” stocks and characterized by low variability, low fundamental risk and smaller losses when markets do badly.

“the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation.”

But freakish, once-in-a-lifetime events are hard to quantify. The fact that an investment is susceptible to a particularly serious risk that will occur infrequently if at all—what I call the improbable disaster—means it can seem safer than it really is.

(a) the stability and dependability of value and (b) the relationship between price and value.

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.

Astute managers will be aware of the many risks that could threaten their businesses and will take action to mitigate or avoid them.

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

Nicholas Taleb calls “lucky idiots,” and in the short run it’s certainly hard to tell them from skilled investors.

It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.

“Single-scenario” investors ignore this fact, oversimplify the task, and need fortuitous outcomes to produce good results.

The best we can do is fashion a probability distribution that summarizes the possibilities and describes their relative likelihood. We must think about the full range, not just the ones that are most likely to materialize. Some of the greatest losses arise when investors ignore the improbable possibilities.

“There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” That’s one of the most important things you can know about investment risk.

Now that investing has become so reliant on higher math, we have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world.

Many futures are possible, to paraphrase Dimson, but only one future occurs.

Return alone—and especially return over short periods of time—says very little about the quality of investment decisions.

Risk can be judged only by sophisticated, experienced second-level thinkers.

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,

But once in a while, something very different happens….

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.

People overestimate their ability to gauge risk and understand mechanisms they’ve never before seen in operation.

Finally and importantly, most people view risk taking primarily as a way to make money.

Underestimating uncertainty and its consequences is a big contributor to investor difficulty.

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

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

That is, high price both increases risk and lowers returns.

In short, in 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.”

Risk-averse investors are conscious of the potential for loss and demand compensation for bearing it—in the form of reasonable prices. When investors aren’t sufficiently risk averse, they’ll pay prices that are too high.

The feeling of safety tends to increase risk while the awareness of risk tends to reduce it.

When worry and risk aversion are present as they should be, investors will question, investigate and act prudently. Risky investments either won’t be undertaken or will be required to provide adequate compensation in terms of anticipated return.

Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety.

“If I can get 10 percent from stocks, I need 15 percent to accept the illiquidity and uncertainty associated with real estate.

This “richening” process eventually brings on elevated price/earnings ratios, narrow credit spreads, undisciplined investor behavior, heavy use of leverage and strong demand for investment vehicles of all types.

People vastly overestimate their ability to recognize risk and underestimate what it takes to avoid it;

“perversity of risk.”

I’m firmly convinced that investment risk resides most where it is least perceived,

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.

when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.

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

It’s just a matter of the price paid for them…. Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.

High absolute return is much more recognizable and titillating than superior risk-adjusted performance.

Whatever few awards are presented for risk control, they’re never given out in good times. The 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.

Risk gives rise to loss only when negative events occur in the environment.

risk control is invisible in good times but still essential, since good times can so easily turn into bad times.

And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.

we never know what lies ahead, but we can prepare for the possibilities and reduce their sting.

“the worst loans are made at the best of times.”

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 qualified of borrowers, if anyone. Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies. This process contributes to and reinforces the economic contraction.

In the financial world, if you offer cheap money, they will borrow, buy and build—often without discipline, and with very negative consequences.

“this time it’s different.” These four words should strike fear—and perhaps suggest an opportunity for profit—for

In the end, trees don’t grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical.

Whether it’s company profitability, capital availability, price gains, or market liquidity, things that inevitably are bound to regress toward the mean are often counted on to improve forever.

I’ve recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both.

three stages of a bull market.

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

“What the wise man does in the beginning, the fool does in the end.”

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

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….

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.

The first emotion that serves to undermine investors’ efforts is the desire for money, especially as it morphs into greed.

greed drives investors to throw in their lot with the crowd in pursuit of profit,

The combination of greed and optimism repeatedly leads people to pursue strategies they hope will produce high returns without high risk; pay elevated prices for securities that are in vogue; and hold things after they have become highly priced in the hope there’s still some appreciation left.

Fear is overdone concern that prevents investors from taking constructive action when they should.

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

Inadequate skepticism contributes to investment losses.

Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

The fourth psychological contributor to investor error is the tendency to conform to the view of the herd rather than resist—even

The fifth psychological influence is envy.

In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.

The sixth key influence is ego

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.

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

They avoid sharing in the riskiest behavior because they’re so aware of how much they don’t know and because they have their egos in check.

capitulation

economic and psychological pressures become irresistible, they surrender and jump on the bandwagon.

Buffett’s famous line about the economics of airlines comes to mind. Aviation is a huge and valuable innovation. That’s not the same thing as saying it’s a good business.

Investors who believe they’re immune to the forces described in this chapter do so at their own peril.

strongly held sense of intrinsic value,

insistence on acting as you should when price diverges from value, enough conversance with past cycles—gained at first from reading and talking to veteran investors, and later through experience—to know that market excesses are ultimately punished, not rewarded, a thorough understanding of the insidious effect of psychology on the investing process at market extremes, a promise to remember that when things seem “too good to be true,” they usually are, willingness to look wrong while the market goes from misvalued to more misvalued (as it invariably will), and like-minded friends and colleagues from whom to gain support (and for you to support).

To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.

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.

And you must have the support of understanding, patient constituencies.

it’s important to remember that “overpriced” is incredibly different from “going down tomorrow.”

it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.

“Nobody goes to that restaurant anymore; it’s too crowded.”

Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates….

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.

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

“investment is the discipline of relative selection.”

The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, get most investors into trouble.

a buy a good one. In general, that means price is low relative to value, and potential return is high relative to risk.

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.

Our goal is to find underpriced assets.

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.

of bargains is that perception has to be considerably worse than reality.

It’s obvious that investors can be forced into mistakes by psychological weakness, analytical error or refusal to tread on uncertain ground. Those mistakes create bargains for second-level thinkers capable of seeing the errors of others.

there aren’t always great things to do, and sometimes we maximize our contribution by being discerning and relatively inactive.

It’s essential for investment success that we recognize the condition of the market and decide on our actions accordingly.

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

You want to take risk when others are fleeing from it, not when they’re competing with you to do so.

They receive margin calls because the value of their assets fails to satisfy requirements agreed to in contracts with their lenders.

investors should work to never put themselves in a position to be a forced seller for these exact reasons.

Those last three words—regardless of price—are the most beautiful in the world if you’re on the other side of the transaction.

The key during a crisis is to be (a) insulated from the forces that require selling and (b) positioned to be a buyer instead.

To satisfy those criteria, an investor needs the following things: staunch reliance on value, little or no use of leverage, long-term capital and a strong stomach.

It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.

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.

most of the forecasts consisted of extrapolations.

Like many forecasters, these economists were driving with their eyes firmly fixed on the rearview mirror,

one likes having to invest for the future under the assumption that the future is largely unknowable.

the other hand, if it is, we’d better face up to it and find other ways to cope than through forecasts.

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.

One key question investors have to answer is whether they view the future as knowable or unknowable.

emphasizing value today over growth tomorrow,

Mark Twain put it best: “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.”

What we need to do is “take the market’s temperature.” If we are alert and perceptive, we can gauge the behavior of those around us and from that judge what we should do.

we must strive to understand the implications of what’s going on around us.

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.

So look around, and ask yourself: Are investors optimistic or pessimistic ? Do the media talking heads say the markets should be piled into or avoided? Are novel investment schemes readily accepted or dismissed out of hand? Are securities offerings and fund openings being treated as opportunities to get rich or possible pitfalls? Has the credit cycle rendered capital readily available or impossible to obtain? Are price/earnings ratios high or low in the context of history, and are yield spreads tight or generous?

The issuance of high yield bonds and below investment grade leveraged loans was at levels that constituted records by wide margins. An unusually high percentage of the high yield bond issuance was rated triple-C, a quality level at which new bonds usually can’t be sold in large amounts. Issuance of debt to raise money for dividends to owners was routine. In normal times, such transactions, which increase the issuers’ riskiness and do nothing for creditors, are harder to accomplish. Debt was increasingly issued with coupons that could be paid with more debt, and with few or no covenants to protect creditors. Formerly rare triple-A debt ratings were assigned by the thousands to tranches of untested structured vehicles. Buyouts were done at increasing multiples of cash flow and at increasing leverage ratios. On average, buyout firms paid 50 percent more for a dollar of cash flow in 2007 than they had in 2001. There were buyouts of firms in highly cyclical industries such as semiconductor manufacturing. In more skeptical times, investors take a dim view of combining leverage and cyclicality.

The seven scariest words in the world for the thoughtful investor—too much money chasing too few deals—provided an unusually apt description of market conditions.

Economy: Vibrant Sluggish
Outlook: Positive Negative
Lenders: Eager Reticent
Capital markets: Loose Tight
Capital: Plentiful Scarce
Terms: Easy Restrictive
Interest rates: Low High
Spreads: Narrow Wide
Investors: Optimistic Pessimistic
Sanguine Distressed
Eager to buy Uninterested in buying
Asset owners: Happy to hold Rushing for the exits
Sellers: Few Many
Markets: Crowded Starved for attention
Funds: Hard to gain entry Open to anyone
New ones daily Only the best can raise money
General Partners hold all the cards Limited Partners have bargaining
power
Recent performance: Strong Weak
Asset prices: High Low
Prospective returns: Low High
Risk: High Low
Popular qualities: Aggressiveness Broad reach Caution and discipline Selectivity

Fooled by Randomness

quality of a decision is not determined by the outcome.

A good decision is one that a logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known

There are two principal elements in investment defense. 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.

you must allow for outliers.

the great majority of sell-side research focuses on a single, most likely scenario and ignores the range of possible outcomes.

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.

Understanding and anticipating the power of correlation—and thus the limitations of diversification—is a principal aspect of risk control and portfolio management, but it’s very hard to accomplish.

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

If you buy when price exceeds intrinsic value, you’ll have to be extremely lucky—the asset will have to go from overvalued to even more overvalued—in order to experience gain rather than loss.

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.

This is one of the reasons that we always think in terms of earnings yield (which is just the inverse of the P/E) rather than in P/Es; doing so allows for easy comparison to fixed-income alternatives.

Widespread disregard for risk creates great risk.

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.

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.

Markets change, invalidating models.

“Beware of geeks with models.”

Leverage magnifies outcomes but doesn’t add value.

It makes little sense to use leverage to try to turn inadequate returns into adequate returns.

Excesses correct.

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.

taking note of the carefree, incautious behavior of others, preparing psychologically for a downturn, selling assets, or at least the more risk-prone ones, reducing leverage, raising cash (and returning cash to clients if you invested for others), and generally tilting portfolios toward increased defensiveness.

When investor psychology is at equilibrium and fear and greed are balanced, asset prices are likely to be fair relative to value. In that case there may be no compelling action, and it’s important to know that, too.

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

Asymmetry—better performance on the upside than on the downside relative to what your style alone would produce—should be every investor’s goal.

asking whether the result you’re expecting is too good to be true.

But people regularly suspend disbelief and accept unreasonable expectations when they’re told free money is available.

just ask “Why me?” When the salesman on the phone offers you a guaranteed route to profit, you should wonder what made him offer it to you rather than hog it for himself. Likewise, but a little more subtly, if an economist or strategist offers a sure-to-be-right view of the future, you should wonder why he or she is still working for a living, since derivatives can be used to turn correct forecasts into vast profits without requiring the investment of much capital.

Buying based on strong value, low price relative to value, and depressed general psychology is likely to provide the best results.