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Howard Marks: The 5 Most Important Things in Investing

Howard Marks (Trades, Portfolio) is a legendary value investor who specializes in deep value investing and special situations, such as credit and distressed debt investing.

Marks is the founder of Oaktree Capital Management, which has over $8 billion in its equity portfolio as of its most recent 13F filing.

Howard Marks: The 5 Most Important Things in Investing
Howard Marks: The 5 Most Important Things in Investing

The firm has had tremendous investment history, producing an 18.8% Internal Rate of Return (IRR) vs. the S&P 500's annual return of 10.4%.

Howard Marks: The 5 Most Important Things in Investing
Howard Marks: The 5 Most Important Things in Investing

This exceptional performance has led Marks to be nicknamed The next Warren Buffett (Trades, Portfolio) by some, and even Buffett reads his investor memos. Here are my top five investing tips that I took away from reading Marks' book, The Most important Thing.

1. Understand risk

According to Marks, risk is not all about volatility as many financial professors will tell you. Instead, risk is the likelihood of losing your initial investment.

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 the possibility of losses.

In order to attract capital, riskier investments have to offer the prospect of higher expected returns. But theres absolutely nothing to say that higher prospective returns have to materialize. Thus, higher risk doesnt always equal higher reward. This should be eye opening wisdom for many investors who chase risky stocks with the hope of higher returns.

As Marks says, Trees dont grow to the sky, and things rarely go to zero. When everyone believes something is risky, their unwillingness to buy can sometimes reduce its price to the point where its not risky at all. A great example of this is buying in a stock market crash; although it may feel more risky, in fact, it is likely to be less risky than buying at the top of a market bubble.

2. Understand bubbles

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

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. Marks has a great quote on bubbles which really gives perspective: People should like something less when its price rises, but in investing they often like it more.

The problem is that in bubbles, attractive morphs into attractive at any price. People often say, Its not cheap, but I think itll keep going up because of excess liquidity, or maybe money printing, earnings growth, etc.

The risk-is-gone myth is one of the most dangerous sources of risk, and a major contributor to any bubble.

3.Understand probabilities

The expected result is calculated by weighing each outcome by its probability of occurring. Theres a big difference between probability and outcome. Probable things fail to happen and improbable things happen all the time. Remember the 6 foot man who drowned in a river which was 5 feet deep on average," as Marks says.

4. Understand cycles

Marks believes everything is governed by cycles, from investor moods to stock market crashes. He even wrote a best selling book on the subject called Mastering the Market Cycle. Marks talks of two rules:

  • 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.

Investors will overvalue companies when theyre doing well and undervalue them when things get difficult. Investment markets follow a pendulum-like swing, 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.

5. Understand great investments

Marks talks about a strategy for finding great investment opportunities. Here is a summary of his approach. Marks says to search for investments that are:

  • Little known and not fully understood;

  • Fundamentally questionable on the surface;

  • Controversial, unseemly or scary (Ex. Peter Lynch's funeral company);

  • Deemed inappropriate for respectable portfolios;

  • Unappreciated, unpopular and unloved;

  • Trailing a record of poor returns;

  • Recently the subject of disinvestment, not accumulation.

This article first appeared on GuruFocus.