The Most Important Thing

No rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly. Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable. An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness.

Human beings are not clinical computing machines. Rather, most people are driven by greed, fear, envy and other emotions that render objectivity impossible and open the door for significant mistakes.

Investor psychology can cause a security to be priced just about anywhere in the short run, regardless of its fundamentals.

Risk arises when markets go so high that prices imply losses rather than the potential rewards they should. Dealing with this risk starts with recognizing it.

Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. To say this another way, many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently.

The fourth psychological contributor to investor error is the tendency to conform to the view of the herd rather than resist—even when the herd’s view is clearly cockeyed.

The fifth psychological influence is envy. However negative the force of greed might be, always spurring people to strive for more and more, the impact is even stronger when they compare themselves to others. This is one of the most harmful aspects of what we call human nature.

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.

Millions of people are competing for each available dollar of investment gain. Who’ll get it? The person who’s a step ahead. In some pursuits, getting to the front of the pack means more schooling, more time in the gym or the library, better nutrition, more perspiration, greater stamina or better equipment. But in investing, where these things count for less, it calls for more perceptive thinking . . . at what I call the second level.

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.

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.

Because theory says in an efficient market there’s no such thing as investing skill (commonly referred to today as alpha) that would enable someone to beat the market, all the difference in return between one investment and another—or between one person’s portfolio and another’s—is attributable to differences in risk. In fact, if you show an adherent of the efficient market hypothesis an investment record that appears to be superior, as I have, the answer is likely to be, “The higher return is explained by hidden risk.”

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. Because of the existence of (a) significant misvaluations and (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.

All that means is that prices aren’t always fair and mistakes are occurring: some assets are priced too low and some too high. You still have to be more insightful than others in order to regularly buy more of the former than the latter. Many of the best bargains at any point in time are found among the things other investors can’t or won’t do. Let others believe markets can never be beat. Abstention on the part of those who won’t venture in creates opportunities for those who will.

other words, an investor has two basic choices: gauge the security’s underlying intrinsic value and buy or sell when the price diverges from it, or base decisions purely on expectations regarding future price movements.

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 process, like tossing a coin.

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.

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

It’s hard to consistently do the right thing as an investor. But it’s impossible to consistently do the right thing at the right time.

No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.

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

Why do I say risk assessment is such an essential element in the investment process? There are three powerful reasons.

Second, when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks.

Third, when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well.

risk equals volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition of risk. It’s my view that—knowingly or unknowingly—academicians settled on volatility as the proxy for risk as a matter of convenience. They needed a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risk do not. The problem with all of this, however, is that I just don’t think volatility is the risk most investors care about. There are many kinds of risk.... But volatility may be the least relevant of them all.

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. To me, “I need more upside potential because I’m afraid I could lose money” makes an awful lot more sense than “I need more upside potential because I’m afraid the price may fluctuate.” No, I’m sure “risk” is—first and foremost—the likelihood of losing money.

But every investor who’s unwilling to throw in the towel on outperformance, and who chooses to deviate from the index in its pursuit, will have periods of significant underperformance. In fact, since many of the best investors stick most strongly to their approach—and since no approach will work all the time—the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up.

Stewards of other people’s money can be more comfortable turning in average performance, regardless of where it stands in absolute terms, than with the possibility that unconventional actions will prove unsuccessful and get them fired.... Concern over this risk keeps many people from superior results, but it also creates opportunities in unorthodox investments for those who dare to be different.

Investors tend to associate exciting stories and pizzazz with high potential returns. They also expect high returns from things that have been doing well lately. These souped-up investments may deliver on people’s expectations for a while, but they certainly entail high risk.

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.

“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.”

Third, risk is deceptive. Conventional considerations are easy to factor in, like the likelihood that normally recurring events will recur. 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.

I realized that because of its latent, nonquantitative and subjective nature, the risk of an investment—defined as the likelihood of loss—can’t be measured in retrospect any more than it can a priori.

“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.

Investment risk is largely invisible before the fact—except perhaps to people with unusual insight—and even after an investment has been exited.

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

but this year, due to the low interest rates, the bar for each successively riskier investment has been set lower than at any time in my career.

First, investors have fallen over themselves in their effort to get away from low-risk, low-return investments.... Second, risky investments have been very rewarding for more than twenty years and did particularly well in 2003. Thus, investors are attracted more (or repelled less) by risky investments than perhaps might otherwise be the case, and require less risk compensation to move to them.... Third, investors perceive risk as being quite limited today. . . .

And, of course, as demonstrated by the experience of Nifty 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. This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. 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.

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

But in my opinion, great investors are those who take risks that are less than commensurate with the returns they earn. They may produce moderate returns with low risk, or high returns with moderate risk. But achieving high returns with high risk means very little—unless you can do it for many years, in which case that perceived “high risk ” either wasn’t really high or was exceptionally well managed.

It’s an outstanding accomplishment to achieve the same return as the risk bearers and do so with less risk. But most of the time it’s a subtle, hidden accomplishment that can be appreciated only through sophisticated judgments.

The pendulum swing regarding attitudes toward risk is one of the most powerful of all. In fact, 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.

In the investment world the term doesn’t mean logical, sensible risk aversion. Rather, fear—like greed—connotes excess. Fear, then, is more like panic. Fear is overdone concern that prevents investors from taking constructive action when they should.

The sixth key influence is ego. It can be enormously challenging to remain objective and calculating in the face of facts like these: • 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.

As an overpriced stock goes even higher or an underpriced stock continues to cheapen, it should get easier to do the right thing: sell the former and buy the latter. But it doesn’t. The tendency toward self-doubt combines with news of other people’s successes to form a powerful force that makes investors do the wrong thing, and it gains additional strength as these trends go on longer. It’s one more influence that must be fought.

But it’s equally obvious that investors allowed their common sense to be overridden in the bubble. They ignored the fact that not all the companies could win, that there would be a lengthy shake-out period, that profitability wouldn’t come easily from providing services gratis, and that shares in money-losing companies valued at high multiples of sales (since there were no earnings) carried great danger.

In short, there are two primary elements in superior investing: • seeing some quality that others don’t see or appreciate (and that isn’t reflected in the price), and • having it turn out to be true (or at least accepted by the market). It should be clear from the first element that the process has to begin with investors who are unusually perceptive, unconventional, iconoclastic or early. That’s why successful investors are said to spend a lot of their time being lonely.

Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t. The best investors I know exemplify this trait. It’s an absolute necessity.

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.

Not only can there be risks investors don’t want to take, but also there can be risks their clients don’t want them to take. Especially in the institutional world, managers are rarely told “Here’s my money; do what you want with it.” The money manager’s job isn’t just to make investments with profit potential, but also to give clients what they want, since most institutional investors are hired to carry out specific assignments in terms of asset class and investment style.

I’m firmly convinced that (a) it’s hard to know what the macro future holds and (b) few people possess superior knowledge of these matters that can regularly be turned into an investing advantage.

If you predict that something won’t change and it doesn’t change, that prediction is unlikely to earn you much money. But accurately predicting change can be very profitable.

one other thing: 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.

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 and overpriced; let’s sell.”

The bottom line for me is that, 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 influences—to consistently hold views that are different from the consensus and closer to being correct. That’s what makes the mainstream markets awfully hard to beat—even if they aren’t always right.

To me, an inefficient market is one that is marked by at least one (and probably, as a result, by all) of the following characteristics:

“The market can remain irrational longer than you can remain solvent.”

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.

The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there.

Extreme market behavior will reverse. Those who believe that the pendulum will move in one direction forever—or reside at an extreme forever—eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously.

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

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.”

Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”

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.”

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 thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account: • 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?

Different and better: that’s a pretty good description 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.

theory should inform our decisions but not dominate them. If we entirely ignore theory, we can make big mistakes. We can fool ourselves into thinking it’s possible to know more than everyone else and to regularly beat heavily populated markets.

Second, the standard for quantification is nonexistent. With any given investment, some people will think the risk is high and others will think it’s low.

Skillful investors can get a sense for the risk present in a given situation. They make that judgment primarily based on (a) the stability and dependability of value and (b) the relationship between price and value. Other things will enter into their thinking, but most will be subsumed under these two.

People vastly overestimate their ability to recognize risk and underestimate what it takes to avoid it; thus, they accept risk unknowingly and in so doing contribute to its creation. That’s why it’s essential to apply uncommon, second-level thinking to the subject.

In all aspects of our lives, we base our decisions on what we think probably will happen. And, in turn, we base that to a great extent on what usually happened in the past. We expect results to be close to the norm (A) most of the time, but we know it’s not unusual to see outcomes that are better (B) or worse (C). Although we should bear in mind that, once in a while, a result will be outside the usual range (D), we tend to forget about the potential for outliers. And importantly, as illustrated by recent events, we rarely consider outcomes that have happened only once a century . . . or never (E)

But processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

And yet, every decade or so, people decide cyclicality is over. They think either the good times will roll on without end or the negative trends can’t be arrested.

This belief that cyclicality has been ended exemplifies a way of thinking based on the dangerous premise that “this time it’s different.” These four words should strike fear—and perhaps suggest an opportunity for profit—for anyone who understands the past and knows it repeats. Thus, it’s essential that you be able to recognize this form of error when it arises.

“Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” The belief that some fundamental limiter is no longer valid—and thus historic notions of fair value no longer matter—is invariably at the core of every bubble and consequent crash.

Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.

the existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it. It does not, however, guarantee it.

Something else to keep in mind: just because efficiencies exist today doesn’t mean they’ll remain forever.

In general, the upside potential for being right about growth is more dramatic, and the upside potential for being right about value is more consistent. Value is my approach. In my book, consistency trumps drama.

Future price changes will be determined by whether it comes to be liked by more people or fewer people in the future.

First, risk is a bad thing, and most level-headed people want to avoid or minimize it. It is an underlying assumption in financial theory that people are naturally risk-averse, meaning they’d rather take less risk than more.

Second, risk can be present even without weakness in the macroenvironment. The combination of arrogance, failure to understand and allow for risk, and a small adverse development can be enough to wreak havoc.

An important question remains: how do they measure that risk?

First, it clearly is nothing but a matter of opinion: hopefully an educated, skillful estimate of the future, but still just an estimate.

The bottom line is that, looked at prospectively, much of risk is subjective, hidden and unquantifiable.

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

“Risk means more things can happen than will happen.”

But to cope with the future it’s not sufficient to have a central expectation; we have to have a sense for the other possible outcomes and their likelihood. We need a distribution that describes all of the possibilities.

Quantification often lends excessive authority to statements that should be taken with a grain of salt. That creates significant potential for trouble.

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.

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.

Likewise, loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.

“You need comfort that the . . . risks and exposures are understood, appropriately managed, and made more transparent for everyone.... This is not risk aversion; it is risk intelligence.”

There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever.

However, there are two concepts we can hold to with confidence: • 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.

Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.

Please note that this memo, written almost ten years ago, perfectly describes the process through which the 2007–2008 financial crisis arose. It wasn’t predictive ability that enabled me to write it—just familiarity with a never-ending underlying cycle.

• 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).

Inefficiencies—mispricings, misperceptions, mistakes that other people make—provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance.

The challenge lies in figuring out who the winners will be, and what a piece of them is really worth today. . . .

To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored.

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 firmly to your views and perhaps buy more as your positions take on the appearance of mistakes and as losses accrue rather than gains.

But that triggered an epiphany: skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.

Our goal isn’t to find good assets, but good buys.

Because the important thing in forecasting isn’t getting it right once. The important thing is getting it right consistently.

Maybe 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.”

That means it’s essential to arrange your affairs so you’ll be able to hold on—and not sell—at the worst of times.

“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.

Therefore, the absence of loss does not necessarily mean the portfolio was safely constructed. So, risk control can be present in good times, but it isn’t observable because it’s not tested.

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

Controlling the risk in your portfolio is a very important and worthwhile pursuit. The fruits, however, come only in the form of losses that don’t happen. Such what-if calculations are difficult in placid times.

Many times over the course of my career, I’ve been amazed by how easy it is for people to engage in willing suspension of disbelief. Thus, the third factor I want to discuss is people’s tendency to dismiss logic, history and time-honored norms.

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.

Skepticism is usually thought to consist of saying, “no, that’s too good to be true” at the right times. But I realized in 2008—and in retrospect it seems so obvious—that sometimes skepticism requires us to say, “no, that’s too bad to be true.”

On average, the predictions were within 5 percent of the levels that prevailed at the time they were made. Like many forecasters, these economists were driving with their eyes firmly fixed on the rearview mirror, enabling them to tell us where things were but not where they were going.

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.

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.

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.”)