Howard Marks On Mistakes, Biases, And The Efficient Market Fallacy
"Mistakes are what superior investing is all about" is how Oaktree's Howard Marks begins his latest treatise, adding that for a trade to turn out to be a major success, the other side has to have been a big mistake. In any trade it is generally safe to say that one side has to be wrong (since win/win transactions are far less common than win/lose) leaving the buyer and seller unequally happy. Marks believes it is highly desirable to focus on the topic of investing mistakes. First, it serves as a reminder that the potential for error is ever-present, and thus of the importance of mistake minimization as a key goal. Second, if one side of every transaction is wrong, we have to ponder why we should think it’s not us. Third, then, it causes us to consider how to minimize the probability of being the one making the mistake. From the real-world 'issues' with the efficient market hypothesis, to behavioral sources of investment error, Marks concludes: "In the end, superior investing is all about mistakes... and about being the person who profits from them, not the one who commits them."
Howard Marks: Investment Theory on Mistakes
According to the efficient market hypothesis, the efforts of motivated, intelligent, objective and rational investors combine to cause assets to be priced at their intrinsic value. Thus there are no mistakes: no undervalued bargains for superior investors to recognize and buy, and no overvaluations for inferior investors to fall for. Since all assets are priced fairly, once bought at fair prices they should be expected to produce fair risk-adjusted returns, nothing more and nothing less. That’s the source of the hypothesis’s best-known dictum: you can’t beat the market.
I’ve often discussed this definition of market efficiency and its error. The truth is that while all investors are motivated to make money (otherwise, they wouldn’t be investing), (a) far from all of them are intelligent and (b) it seems almost none are consistently objective and rational.
Rather, investors swing wildly from optimistic to pessimistic – and from over-confident to terrified – and as a result asset prices can lose all connection with intrinsic value. In addition, investors often fail to unearth all of the relevant information, analyze it systematically, and step forward to adopt unpopular positions. These are some of the elements that give rise to what are called “inefficiencies,” academics’ highfalutin word for “mistakes.”
I absolutely believe that markets can be efficient – in the sense of “quick to incorporate information” – but certainly they aren’t sure to incorporate it correctly. Underpricings and overpricings arise all the time. However, the shortcomings described in the paragraph just above render those mispricings hard to profit from. While market prices are often far from “right,” it’s nearly impossible for most investors to detect instances when the consensus has done a faulty job of pricing assets, and to act on those errors. Thus theory is quite right when it says the market can’t be beat... certainly by the vast majority of investors.
People should engage in active investing only if they’re convinced that (a) pricing mistakes occur in the market they’re considering and (b) they – or the managers they hire – are capable of identifying those mistakes and taking advantage of them. Unless both of those things are true, any time, effort, transaction costs and management fees expended on active management will be wasted. Active management has to be seen as the search for mistakes.
Behavioral Sources of Investment Error
As described above, investment theory asserts that assets sell at fair prices, and thus there’s no such thing as superior risk-adjusted performance. But real-world data tells us that superior performance does exist, albeit far from universally. Some people find it possible to buy things for less than they’re worth, at least on occasion. But doing so requires the cooperation of people who’re willing to sell things for less than they’re worth. What makes them do that? Why do mistakes occur? The new field of behavioral finance is all about looking into error stemming from emotion, psychology and cognitive limitations.
If market prices were set by a “pricing czar” who was (1) tireless, (2) aware of all the facts, (3) proficient at analysis and (4) thoroughly rational and unemotional, assets could always be priced right based on the available information – never too low or too high. In the absence of that czar, if a market were populated by investors fitting that description, it, too, could price assets perfectly.
That’s what the efficient marketers theorize, but it’s just not the case. Very few investors satisfy all four of the requirements listed above. And when they fail, particularly at number four – being rational and unemotional – it seems they all err in the same direction at the same time. That’s the reason for the herd behavior that’s behind bubbles and crashes, the biggest of all investment mistakes.
According to the efficient market hypothesis, people study assets, assess their value and thereby decide whether to buy or sell. Given its current value and the outlook for change in that value, each asset’s current price implies a prospective return and risk level. Market participants engage in a continuous, instantaneous auction through which market prices are updated. The goal is to
set prices such that the relationship between each asset’s potential return and risk – that is, its prospective risk-adjusted return – is fair relative to all other assets.
Inefficiencies – mispricings – are instances when one asset offers a higher risk-adjusted return than another. For example, A and B might seem equally risky, but A might appear to offer a higher return than B. In that case, A is too cheap, and people will sell B (lowering its price, raising its potential return and reducing its risk) and buy A (raising its price, lowering its potential return and increasing its risk) until the risk-adjusted returns of the two are in line. That condition is called “equilibrium.”
It’s one of the jobs of a functioning market to eliminate opportunities for extraordinary profitability. Thus market participants want to sell overpriced assets and buy underpriced assets. They just don’t do so consistently.
Most investment error can be distilled to the failure to buy the things that are cheap (or to buy enough of them) and to sell the things that are dear. Why do people fail in that way? Here are just a few reasons:
- Bias or closed-mindedness – In theory, investors will shift their capital to anything that’s cheap, correcting pricing mistakes. But in 1978, most investors wouldn’t buy B-rated bonds – at any price – because doing so was considered speculative and imprudent. In 1999, most investors refused to buy value stocks – also at any price – because they were deemed to lack the world-changing potential of technology stocks. Prejudices like these prevent valuation disparities from being closed.
- Capital rigidity – In theory, investors will move capital out of high-priced assets and into cheap ones. But sometimes, investors are condemned to buy in a market even though there are no bargains or to sell even at giveaway prices. In 2000, in venture capital, there was “too much money chasing too few deals.” In 2008, CLOs receiving margin calls had no choice but to sell loans at bankruptcy prices. Rigidities like these create mispricings.
- Psychological excesses – In theory, investors will sell assets when they get too rich in a bubble or buy assets when they get cheap enough in a crash. But in practice, investors aren’t all that cold-blooded. They can fail to sell, for example, because of an unwarranted excess of optimism over skepticism, or an excess of greed over fear. Psychological forces like greed, fear, envy and hubris permit mispricings to go uncorrected... or become more so.
- Herd behavior – In theory, market participants are willing to buy or sell an asset if its price gets out of line. But sometimes there are more buyers for something than sellers (or vice versa), regardless of price. This occurs because of most investors’ inability to diverge from the pack, especially when the behavior of the pack is being rewarded in the short-run.
The foregoing goes a long way to support Yogi Berra’s observation that “In theory there is no difference between theory and practice. In practice there is.”
Theory has no answer for the impact of these forces. Theory assumes investors are clinical, unemotional and objective, and always willing to substitute a cheap asset for a dear one. In practice, there are numerous reasons why one asset can be priced wrong – in the absolute or relative to others – and stay that way for months or years. Those are mistakes, and superior investment records belong to investors who take advantage of them consistently.