Howard Marks’ Four Investing Life Lessons

Howard Marks is an investing titan, so his memos are usually worth paying attention to. His latest one, “Fewer losers, or more winners”, details how Marks manages risk, the importance of having more winners than losers, his take on why most active managers fail to beat the market, and how to generate “alpha” opportunities. Let’s take a closer look at his life lessons, and see how they could improve your own investment acumen.

Anything but average.

Marks learned an important lesson back in 1990. A seasoned fund manager disclosed to him that over the last 14 years, he had consistently ranked between the 27th and 47th percentile of his peers. Hardly a stellar performance, but solid enough to place him in the top-fourth percentile over the 14-year period as a whole. Marks took that to show that if you perform a little better than average every year and avoid disastrous results in bad times, then your overall performance will look after itself.

So avoid the losers by undertaking careful research and responsible risk management, and the winning will take care of itself, Marks believes. After all, if you always aim for the top five percent of returns, you’ll end up taking more risks – and that’ll give you a higher chance of landing in the bottom five percent if markets don’t go your way.

Risk control, not risk avoidance.

You need to take some risk in investing, of course, otherwise you’ll essentially eliminate your chances of making returns. But risk control doesn’t mean avoiding all risk, rather it advises against taking risks that aren’t well compensated or are beyond what you can deal with.

Think of a game of tennis. Wimbledon players shoot big shots in a bid to outdo their opponent – in other words, they’re hitting more winners than losers. But head down to your local club, and you’ll likely see a more careful and defensive game, with players trying their best to keep their balls within the lines. Marks reckons that shows there’s no one way to be successful: you can win by having a few winners but fewer losers, or by having a lot of losers and even more winners. Neither maximizing winners nor minimizing losers is necessarily enough, rather it’s all in the balance. That’s just like investing: top investors like Buffett can aim for winners with confidence, but most investors should just try their best to avoid taking too many losing shots.

Passive investing often wins.

Marks’ memo agreed that active investors tend to underperform the market due to a typically accepted combination of market efficiency, high management fees, and the impact of investor error. But Marks also highlighted another reason: active investors’ need for winners.

Case in point: this year a small number of stocks – the so-called “magnificent seven” of Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta – have accounted for a disproportionately major share of overall stock market gains. This phenomenon of a few stocks or a specific sector driving the market upward has happened several times over Marks’ career. In 2017, it was the “FAANGs”: Facebook, Amazon, Apple, Netflix, and Google/Alphabet. Oil companies have been responsible in the past, as well as the “Nifty 50” – companies like Kodak and Xerox – in the 1960s. At all of these times, an active investor would likely have underperformed unless they had an index weighting in these winners.

Now, let’s imagine that an investor did hold an index-sized position in Apple in 2003, when the stock was trading at $0.37 (adjusting for stock splits). The stock hit $15 in 2013 and now hovers around $175, but it’s highly likely the investor would’ve been tempted to sell at some point before those highs. The problem: if they did sell some of their Apple stock, as human nature would encourage, their then-smaller position would then lead to underperformance versus the index if the stock continued to rally. So despite picking the winner, the savvy investor would still end up trailing behind passive index-tracking investors.

Marks’ risk-return profiles of different assets and strategies.

In college, Marks was taught that the relationship between risk and return went like this:

A basic model of risk and return from Marks’ college. Source: Oaktree.

That chart’s pretty straightforward, mind you, implying that higher risk means higher rewards – no ifs and buts about it. Marks revised the relationship between risk and return to something that looks more like this:

Marks’ risk and return profile. Source: Oaktree.

In Marks’ version, higher risk still correlates to higher returns – but with a greater range of outcomes, too. In other words, riskier investments introduce the potential for higher returns, but also the possibility of bigger losses. Applying this to various assets, Marks produced the following risk and return profiles:

Asset classes risk-return profiles. Source: Oaktree.

You can see that bonds’ potential returns are on the smaller side, but with less of a range between their best and worst outcomes. Venture capital investments offer the most massive returns and most disastrous losses, while stocks sit somewhere in the middle.

The risk and return profiles of different asset classes. Source: Oaktree.

The graph shows that if your main goal is to minimize losses, you limit your potential returns. Riskier bets, meanwhile, give you a higher potential payoff, but they come with a much wider range of possible outcomes (read: bigger losses).

What’s the opportunity?

The “Efficient Market Hypothesis” says that markets price securities such that (a) their price equals their intrinsic value and (b) investors’ incremental risk is rewarded fairly. But as Einstein said: “In theory, there is no difference between theory and practice. In practice, there is.” Well, in practice, Marks firmly believes that markets are sometimes overpriced and sometimes underpriced, with investor sentiment – positive or negative – driving prices away from their fair value.

So market prices don’t always reflect an asset’s true value, says Marks. And in that case, the aim for investors is to alter the risk-return distribution we saw in the graphs, searching for high-return opportunities that don’t carry equal downside risk. By finding those assets, an investor’s range of returns would not be symmetrical, instead boasting a higher probability of a positive outcome than a negative one.

Alpha generators’ risk-return profile. Source: Oaktree.

To do this, investors must increase the likelihood of a positive outcome, rather than accepting an equal balance of high risk and high reward. That means a truly active investing strategy, with a keen eye on changing conditions, prices, and risk factors. The end goal is what Marks explains as “alpha”: an investment’s return that goes over and above the benchmark. Investors produce alpha by applying careful timing and skill to the market, picking opportunities with outsized upside potential versus downside risk. Thing is, such opportunities are hard to find, rarely cropping up in markets. Most investors, then, don’t bring in alpha-level returns.

Luckily, there are simpler ways to hunt for returns. You could check out the core holdings in passive ETFs, since they provide broad market exposure. And when a certain stock or sector seems particularly attractive for its amount of risk, it could be time for you to adopt the tricks of a successful alpha-generating investor. Just remember to stay alert and nimble.