The other day, I watched a conversation with Howard Marks on Youtube. I was struck by how clearly and succinctly he described his approach to investing and how suitable it was as the foundation of an equity investing strategy for practically anyone.
For those who haven't heard of him, Marks has been a successful fund manager known as an excellent writer and speaker about investing. His writing is mainly in the form of well-known memos on investing that he sends out. Warren Buffett himself has said that when a memo from Marks arrives, he drops everything to read it, so let's follow his example.
Marks says that risk control and consistency are key elements in his investing philosophy. Interestingly, he does not mention stock selection as key. Why is that? He says something surprising for a professional fund manager, "Although it's not easy to believe at this moment, I think it's easy to make money in the markets." There's a nuance here when he adds, "It's especially easy when the markets go up, and in seven or eight years out of ten, the markets do go up so that's not a problem ... you can make money by ignoring risk and abandoning risk control and seven or eight years out of ten that'll work great. In the other two or three years, not having risk control will cause serious damage."
However, the temptation to take excessive risk in the good times is too strong for most investors, "The truth is that in the good years, the highest returns often go to the person who takes the most risk. We try to have average or slightly above average performance in the good years. By the way, I don't think it's important to beat the market in the good years because everybody makes a lot of money anyway. Average is good enough, but one should be substantially above average in the bad years ... the combination of the two will give you above average performance over the long run with below-average volatility and risk." This consistency is what makes Marks a great fund manager. He has more to add on what he does NOT do: market timing and investing based on macro numbers. He says that it's simply not possible to do these things accurately.
I concur with Howard Marks and the investment philosophy that Value Research espouses. We are obsessed with the best investments, the best being defined as the ones with the highest returns. Not just the highest returns, but the highest recent returns when we are investing. These are inevitably the riskiest investments. As pointed out above, when the markets are rising, then the maximum returns are generated by the riskiest investments. And if you ask how to exercise the risk control that Marks talks about, then my reply will be that you already know!
Risk control consists of all our old friends that every investor is already familiar with: choosing stocks based on fundamental strengths, buying at a reasonable price, averaging your cost, diversifying between sectors and industries, diversifying across company sizes, and increasingly, diversifying geographically as well. One problem is that individual equity investors who take a portfolio approach are scarce. The same is true of equity mutual fund investors, but at least the fund manager has a portfolio approach in mutual funds. This is important because the risk control that Marks talks about can often only be achieved by balancing different types of assets and different stocks. When gains are coming quickly, investors don't stop saying, "This is a good stock to buy, but I shouldn't do it because I already have too much exposure to this industry." This kind of portfolio-level awareness is often not there.
Regardless of how one does that, the takeaway is clear: almost everyone can make money when markets are rising. The real skill is preserving those returns when the going is better.
Suggested read: True and false lessons from the 2008 crash