Howard Marks: How to Maintain a Good Investment Mindset?

Source: The Intelligent Investor.

Howard Marks, co-founder of Oak Tree Capital, was a guest on the interview program "Global Money Talk" last October, discussing some of the most important aspects of investing.

This is a Korean program, so many of the host's questions differ significantly from previous interviews.

Howard's eloquent words this time are truly suitable for ordinary investors.

Especially regarding how to maintain a good mindset and how to make decisions based on one's own situation, capacity, and preferences. He mentioned that there are no universally applicable principles; taking profits or cutting losses, or holding long-term, are all decisions that concern each individual, depending on what they value more. Because when making decisions, there is no decision that is definitively right or wrong; the final outcome is also a matter of probability.

1. It is difficult for ordinary people to make correct decisions based on market information

Host: I would like to start with one of your recent memos, "Mr. Market's Misjudgment." In the memo, you discuss how meaningless statements in the market are often given too much weight, and how a specific development can be interpreted positively or negatively based on market sentiment.

This reminds me of a quote from Amos Tversky: people accept any explanation that can fit the facts. In other words, price behavior can sometimes become a useful source of information.

So, could you provide us with a "user manual" on how to use price behavior as a source of information?

Howard: Of course. But this is a complex issue, and there are no simple answers in the investment world.

Your reference to Tversky's point is important. People always ask, why did that happen? Sometimes the answer is that there is no particular reason.

This is a randomness and a form of irrationality. You know, people often say, he is a good person, why did he die? Well, there may be no correlation.

This is a good company; why did the stock price drop? Sometimes, "who knows" is the correct answer.

Not only in the investment world but generally, people do not like to have "who knows" as an answer in life.

So, as Tversky said, everyone tries to find an explanation to give meaning to things.

Sometimes you cannot explain it.

I wrote a memo titled "What Does the Market Know?". My conclusion is that the market knows nothing.

The market is not a genius with high IQ; it is merely a collection of the voting results of all participants. Therefore, by definition, it is no smarter than average.

Nevertheless, sometimes price fluctuations are meaningful. You can treat it as a signal to think about issues and conduct some research.

When you see a stock rise or fall sharply, you might try to find out if there is an obvious reason. Then try to judge whether the stock price's reaction to this reason is excessive or insufficient. Perhaps this will tell you something worth doing But I want to emphasize, and I will frequently emphasize, that reaching these conclusions requires a very high level of expertise, experience, and insight, which most people do not possess.

So, for the average person, seeing a stock rise 20% this week and then asking why it has risen? Is a 20% increase an overreaction or an underreaction? Will it continue to rise? Should I buy it? Most people do not have the ability to make such decisions.

If you try to do so, you are essentially deceiving yourself.

II. Everyone needs to find a suitable strategy for themselves

Host: In that memo, you also mentioned that there are no fixed rules in investing that can always be relied upon to produce the same results. However, investors often create rules based on their experiences, mainly to prevent repeating the same mistakes.

Rules are not perfect, but they can help investors maintain discipline. Do you have any rules you would like to share with everyone?

Howard: There is an old saying that rules are meant to be broken.

You can establish some general policies. But I think it’s important to be ready to break those rules when necessary.

For example, some people adopt a rule: if you buy a stock and it drops by X percent, you should sell it. This is called a "stop-loss."

Let’s say you say, if I buy a stock and it drops by 10%, I will sell it. You need to think about what that means. It means that if you sell every stock that drops by 10%, you will never lose 20%, 30%, or 40%.

But sometimes you encounter a situation where you buy a stock, it drops by 10%, you sell it, and then it rises by 100%, and you miss out on all those opportunities.

No rule can help you deal with that situation. It’s not that a drop of 10% or 20% is fixed; there is no automatic rule that can guarantee your safety while also preventing you from missing opportunities.

You know, my approach has always been that if you’ve made a lot, you should sell some. This way, if the high point is temporary, you won’t give back all your gains.

But the issue is not whether (partial profit-taking) is right or wrong; it’s whether it is suitable for you at the moment.

Just like the stop-loss action, it can prevent large losses, but it can also cause you to miss some successful opportunities. You have to decide which aspect is more important to you.

It depends on your financial situation, your personality, and similar factors.

I would use a partial profit-taking approach, for example, selling some after a 30% rise, and then selling more after another 30% rise.

So everyone needs to find a suitable strategy for themselves; perfection is not possible.

III. Maintaining a calm mindset in investing and life

Dan: Recently, you had a conversation with your partner Bruce Karsh and chess grandmaster Maurice Ashley. In that conversation, Bruce talked about the importance of maintaining inner peace as an investor I completely agree with this point; it is indeed very important. Can you tell us how to achieve this? This also relates to the question you mentioned about "what is right for yourself."

Howard: This is also related to my minor in college—Asian Studies.

There is a lot in Asian Studies about contentment, inner peace, and acceptance.

Well, there isn't a manual on how to achieve these goals. However, if you want to change your personality, which is what we are talking about, it requires deliberate practice.

You have to ask yourself, how can you attain greater tranquility? One important point is that you cannot be a perfectionist. It is difficult to achieve perfection in investing.

I used to have a friend, and we often joked with each other.

One day we decided to list all the ways you could possibly go wrong. The first was that you buy in, and the stock price drops; the second is that you don't buy in, and the stock price rises; the third is that it goes up first, then you buy in, and it drops again; the fourth is that you buy in, it drops, you sell, and then it goes up again; and the fifth situation is that it goes up, you sell, and it continues to rise.

There are countless ways to go wrong. There is only one way to be right, which is that you buy in, it goes up, and then you sell, and it never goes up again.

But you can't always do that, right?

So you have to achieve a sense of peace in all aspects of life, not just in investing.

You have to accept that some things you buy will go down, and some things you buy will go up, and after you sell, they may continue to rise.

You can't drive yourself crazy in pursuit of absolute correctness because that is simply impossible.

When I was young, I often heard John F. Kennedy quote this line: "Grant us the courage to change the things we can, serenity to accept the things we cannot change, and wisdom to know the difference."

I think this is one of the greatest quotes.

Dan: The environment that investors are in is very important for achieving this inner peace. Have you established a culture at Oak Tree for your investment decision-makers that can maintain this peace?

What types of strategies are you pursuing, and which strategies are you deliberately avoiding? What is your tolerance for losses and mistakes?

Howard: We are very fortunate because we invest in what is called "credit."

Credit means we lend money to others, and they sign a contract with us, promising to pay interest regularly and then repay us at some point.

So our outcomes are not completely open; our outcomes are defined by contracts.

Most of the time, people will honor their commitments and pay interest on time, and we will receive the expected returns. Sometimes they won't pay, and as unpaid creditors, we have the right to seek solutions.

Most of the time, this process can be resolved.

When you are a credit investor or lender, the upside potential of returns is limited, unlike holding Nvidia, Microsoft, or Amazon and getting huge returns. But on the other hand, your losses are also minimal Well, we rarely have large losses. So this aligns very well with my personality, as well as our company culture and our clients' expectations.

When I joined the bond department at Citibank 46 years ago, I discovered this investment approach that suits my personality, genes, and intellectual structure.

You just mentioned how to establish this culture, right?

I think the most important point in culture is to avoid blame. I want everyone to make the right decisions, but I accept that no one can make only the right decisions.

For all of us, it's a matter of "hit rate."

If a person supports a losing investment, first, it's not uncommon; second, it's understandable; third, it doesn't mean that this person is a bad person or that they are lazy, and this person should not be criticized for it.

Imagine if you were a baseball pitcher, and every time you threw a bad pitch or the opponent hit a home run, you were criticized. How would that be?

We try to avoid blame and shame while understanding the limits of human behavior and what is achievable.

Of course, if someone repeatedly makes wrong decisions over a long period, then we can conclude that this person may not be suitable for the job, and may not be suitable to work at Oak Tree Capital.

IV. Pursue a large number of reasonable successes and avoid large failures

Dan: Is it more appropriate to apply this philosophy in bond investing than in stock investing?

Howard: Our philosophy is to pursue a large number of reasonable successes and avoid large failures.** Debt investment is designed for this purpose. I wrote a memo titled "Fewer Losers or More Winners," which is the core of this philosophy.

Every audience member who wants to become an investor should ask: Is their goal to outperform the market, or are they okay with average performance?

You know, average performance is actually quite good. In the United States, the S&P 500 index has grown at an average annual rate of about 10% over the past hundred years, which means if you had $1 a hundred years ago, you would now have about $15,000. That's not bad, right?

And that's just the average.

Now, most people won't live a hundred years or be able to invest for a hundred years, but even so, if your annual investment return is 10%, your capital doubles every 7 years. So if you can sustain that for 35 years, it will double 5 times, turning $1 into 2, 4, 8, 16, 32.

If you want to outperform the average, I don't encourage amateur investors to pursue that goal because amateur investors usually don't have the ability to outperform the average. They should gladly accept the average.

The benefit is that with tools like index funds, you can ensure average returns at a lower cost.

You might lose money, but you won't fall below average.

If someone says, "No, I'm not satisfied with average; I want to outperform the average, and I know I might fail."

This leads to my memo: Which path to success will you choose? Do you want to achieve more success than the average investor, or do you want to reduce failures? Or both? But this is difficult to achieve because a defensive mindset can help you minimize failures, while an offensive mindset is a necessary condition for achieving more success. It's hard to possess both mindsets simultaneously.

So you should ask yourself, "What kind of person am I? Which strategy is more suitable for me?"

I like our approach; it's much better for both myself and my clients than sometimes facing complete failure after a "full-on strike."

But everyone has to face this question. Look at NVIDIA; it rose more than four times last year. The question is, will you feel regret because you didn't buy it?

Human nature will make you feel regret, but you must remind yourself, "Wait a minute, didn't I say I wanted to minimize failures? I can accept the outcome of missing all the winners."

There is a strong sense of "fear of missing out" (FOMO) in human nature, and we feel very uncomfortable when we see others succeed, which is detrimental to investing.

There is a book about bubbles and crashes where the author says nothing harms your mental health more than seeing your friends get rich.

Unfortunately, that's human nature. We must do our best to overcome it.

Five, what constitutes "a good decision" is difficult to attribute from a human nature perspective.

Dan: One of my favorite stories in your memo is about a friend of yours who wished he had bought all of Malibu for $300,000 like the Ringe family did back in 1892. And you said he would sell it when it reached $600,000.

I think holding long-term compounding growth stocks in stock investing is very difficult, as difficult as finding such a stock. The difficulty lies in the prudent approach of rebalancing assets. So, is making a significant profit from long-term compounding growth stocks really just luck?

Howard: I wouldn't say it's just luck, but it does require a bit of luck.

Because you bought a stock, and it doubled. Uh-huh. You decided not to sell it. If it continues to appreciate, there is indeed a bit of luck involved.

You can never say, "Oh no, this is definitely going to happen. This is obviously a wise decision."

At every moment in the market, you see the price of a stock, bond, or real estate and then ask yourself whether it is fair, too high, or too low. And there are no scientific tools to determine these things.

You have to make a judgment.

The question is whether your judgment is lucky. Well, luck sounds like it's entirely based on chance, like rolling dice. It's not like that.

Even so, we are making judgments every day about whether something's price is reasonable, too high, or too low. Using the word "luck" is not entirely appropriate.

When a decision is successful, it is indeed a combination of making the right decision and having some luck. Life turns out as you expected, or even better than expected, and thus you profit.

I mentioned Amazon in one of my memos; it was sold for $90,000 in 1999 and dropped to $6,000 in 2001.

The question is, if you bought in at $6,000, would you sell at $12,000? Many people would sell when it doubles. Would you sell at $12,000? What about when it reaches $35,000? A 5-fold increase. What about $60,000? A 10-fold increase.

When it rises to $600,000, you've already made 100 times your investment.

Isn't the prudent approach to sell some? Clearly, if you sell part of it, you can't let it all stay there to continue growing.

When I wrote that memo, it had already risen to $330,000.

If you know someone who bought Apple at $6 and still holds it when it rises to $33,000, never selling a single share. You have to look at this person; they made 500 times their investment but never sold a share. What if it crashes?

So, back to that question: what is your mindset? What is your character? If something rises from $6 to $3,000 and then falls back, how would you feel?

For most of us mere mortals, we might sell some at $600, then sell some more at $3,000, and hope things go in a good direction, right?

This goes back to the issue of human nature. Human nature is a bit complex. Financially, you can tell if a decision was a good one by the outcome. But on a human level, describing a good decision can be very challenging.

6. The market is currently in a neutral state; the economy won't recession tomorrow

Dan: Got it. Let's slightly change the topic. What do you think about the recession in 2020? Was it a real recession? Are we just in a normal economic cycle? Or was it just a disruption, and now we have moved beyond the usual cycle?

Howard: That's a great question. I've said before, rules are meant to be broken.

There’s a rule that a recession happens every 8 to 10 years. If you don't count that one as a normal recession, then we are now in the 15th or 16th year, right? By that logic, we should be facing a recession tomorrow.

But I'm quite sure there won't be a recession tomorrow.

But no one can say whether it was a recession. Was it a normal experience? Did it reset the clock? Will it be 2008, 2028, or 2030? No one can say for sure. It’s obviously foolish to blindly rely on the 8 to 10-year rule.

I would say, my view is, I don't know.

But when I observe the environment around me, I don't see serious excess in the economy. I don't see overly enthusiastic consumption, I don't see excessive inventory buildup, and I don't see a lot of construction cranes in the sky indicating overbuilding.

When I read the newspapers, there are some good news and some bad news.

One day they say we might face a resurgence of inflation, and the next day they say we will soon encounter an economic recession.

This tells me that the current situation is in a neutral state.

In this neutral state, there are no significant conclusions to be drawn. There are no high-probability judgments about our economic condition.

So I say nothing.

Dan: A frenzied market usually has what I call "culprits," which is often where the frenzied behavior begins Howard: I would say that enthusiasm needs something to catalyze it.

I guess your question is whether you see the presence of these culprits?

Dan: Based on what you just said, I guess the answer is probably "no," you don't see any such situation. Over the past few decades, the biggest excesses have not been in the economy, but in the financial markets.

Howard: During the 1999-2000 period, we had a bubble in tech stocks, excessive optimism. In 2008, we also had a bubble in real estate and its related debts.

Although we didn't have significant excesses in the real economy, we still experienced some severe recessions because the financial sector's over-investment caused damage and dragged down the economy.

So, you're right, I don't see that culprit at the moment.

By the way, I don't think the stock market is crazily high right now. It's a bit high, but far from crazy. I also don't think the credit market is very unreasonable right now, just (too) a bit complacent.

Some contrarian investors like me might worry about things, but it's not at a point where it makes it difficult to move forward.

Dan: Can you share some?

Howard: It's now the third quarter of 2024, and if you go back two years, the world was very pessimistic, which meant high investment returns because people felt very down, and asset prices were quite reasonable.

Now most people are relatively optimistic. The stock market has rebounded for nearly two years.

You know, I like to buy when everyone is pessimistic, and the prices do not reflect optimistic sentiment. And today, most people are quite optimistic, not to say crazily optimistic, but almost devoid of any pessimistic sentiment.

I like to buy when there is a lot of pessimistic sentiment reflected in the prices, and that is not the case today. It is investable today, but it is not worth getting excited about.

Seven, with probabilistic thinking, your life will be happier

Dan: Most people think about investments from the perspective of "whether it is right," while you have always thought about problems from a probabilistic perspective? Or has this way of thinking evolved over time?

Howard: That's a great question, as if no one has asked me before.

I think it's a mature process.

I entered the investment industry in 1969, and in 1978 I transitioned to actual fund management, joining Citibank's bond department. At some point between 1978 and 1988, I stopped thinking from the "yes or no" perspective and strengthened my probabilistic thinking.

In 1963, there was a World’s Fair in Flushing, New York, where IBM had an interesting exhibit.

There were two sheets of acrylic connected by a series of rods, with an opening at the top. They poured a bunch of small balls from the top, and the balls came down. The balls hit the rods and then piled up at the bottom in a shape.

I was there, and that was my first exposure to the concept of probability when I was 17.

Most things happen as expected, but some things happen in unexpected ways. Occasionally, things happen that you think will never happen, which we call "tail events." This is my perspective on life, which requires high attention.

In a memo, I told a story. It was the Super Bowl match in 2016 (I'm not very good at remembering the dates of football games), where the Carolina Panthers faced the Denver Broncos.

At that time, there was a former football player who had never been to the University of Chicago and did not hold a Ph.D. in finance, but someone asked him, "Who do you think will win?" He gave a very clever answer, saying, "The Carolina Panthers will win 8 out of 10 times." But he added an important statement: "This time could be one of those other two times."

Most people wouldn't include that latter half of the sentence. But in reality, there are two times when Denver would win. And sometimes, that’s just how it happens.

You have to get rid of black-and-white thinking; I have always emphasized this, whether in investing or in life.

When you are dealing with future events, you never know what the outcome will be, and you must realize that. This way, you will become a happier and more efficient person.

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