Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 17 “The Most Important Thing Is…Investing Defensively” — a rather apt topic given today’s market environment.



Psychology, Capital Preservation, Expected Return, Risk, Opportunity Cost

“What’s more important to you: scoring points or keeping your opponent from doing so? In investing, will you go for winners or try to avoid losers? (Or, perhaps more appropriately, how will you balance the two?) Great danger lies in acting without having considered these questions.

And by the way, there’s no right choice between offense and defense. Lots of possible routes can bring you to success, and your decision should be a function of your personality and leanings, the extent of your belief in your ability, and the peculiarities of the markets you work in and the clients you work for.”

“Like everything in investing, this isn’t a matter of black and white. The amount of risk you’ll bear is a function of the extent to which you choose to pursue return. The amount of safety you build into your portfolio should be based on how much potential return you’re willing to forego. There’s no right answer, just trade-offs…Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in the good times, investors must choose between the two.”

Are capital preservation (defense, avoiding losers, etc.) & expected return (offense, going for winners, etc.) mutually exclusive concepts? Perhaps in the short-run, but in the long-run, they are two side of the same coin. Avoiding loss is essential to capital compounding over time. This is because the effects of compounding math are not symmetrical. A 50% loss in one period requires a 100% in a subsequent period just to break even! See our previous article titled: “Asymmetry Revisited” for more on the interplay between capital preservation and compounding.



Capital Preservation, Volatility, Diversification, Leverage

“But what’s defense? Rather than doing the right thing, the defensive investor’s main emphasis is on not doing the wrong thing.

Is there a difference between doing the right thing and avoiding doing the wrong thing? On the surface, they sound quite alike. But when you look deeper, there’s a big difference between the mind-set needed for one and the mind-set needed for the other, and a big difference in the tactics to which the two lead.

While defense may sound like little more than trying to avoid bad outcomes, it’s not as negative or non-aspirational as that. Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.

There are two principal elements in investment defense. The first is the exclusion of losers from portfolios…and being less willing to bet on continued prosperity, and rosy forecasts and developments that may be uncertain. The second element is the avoidance of poor years and, especially, exposure to meltdown in crashes…this aspect of investment defense requires thoughtful portfolio diversification, limits on the overall riskiness borne, and a general tilt toward safety.

Concentration (the opposite of diversification) and leverage are two examples of offense. They’ll add to returns when they work but prove harmful when they don’t: again the potential for higher highs and lower lows from aggressive tactics. Use enough of them, however, and they can jeopardize your investment survival if things go awry. Defense, on the other hand, can increase your likelihood of being able to get through the tough times and survive long enough to enjoy the eventual payoff from smart investments.”



Psychology, Luck, Process Over Outcome

“The choice between offense and defense investing should be based on how much the investor believes is within his or her control…But investing is full of bad bounces and unanticipated developments…The workings of economies and markets are highly imprecise and variable, and the thinking and behavior of the other players constantly alter the environment…investment results are only partly within the investors’ control…The bottom line is that even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match.”

“Playing for offense – trying for winners through risk bearing – is a high octane activity. It might bring the gains you seek…or pronounced disappointment. And there’s something else to think about: the more challenging and potentially lucrative the waters you fish in, the more likely they are to have attracted skilled fishermen. Unless your skills render you fully competitive, you’re more likely to be prey than victor. Playing offense, bearing risk and operating in technically challenging fields mustn’t be attempted without the requisite competence.”

Psychology plays an integral role in successful investing. One must learn to distinguish between the impact of process (avoiding the mis-hits) vs. the outcome (sometimes uncontrollable), and to not be deterred by the occasional but inevitable “bad bounce.” Additionally, there’s the self-awareness and honesty requirement so that one can exercise discipline and remove oneself from the game if/when necessary.



Psychology, Trackrecord

“Investing is a testosterone-laden world where too many people think about how good they are and how much they’ll make if the swing for the fences and connect. Ask some investors of the ‘I know’ school to tell you what makes them good, and you’ll hear a lot abut home runs they’ve hit in the past the home runs-in-the-making that reside in their current portfolio. How many talk about consistency, or the fact that their worst year wasn’t too bad.”

“One of the most striking things I’ve noted over the last thirty-five years is how brief most outstanding investment careers are. Not as short as the careers of professional athletes, but shorter than they should be in a physically nondestructive vocation.

Where’d they go? Many disappeared because organizational flaws render their game plans unsustainable. And the rest are gone because they swung for the fences but struck out instead.

That brings up something that I consider a great paradox: I don’t think many investment managers’ careers end because they fail to hit home runs. Rather, they end up out of the game because they strike out too often – not because they don’t have enough winners, but because they have too many losers. And yet, lots of managers keep swinging for the fences.”

“Personally, I like caution in money managers. I believe that in many cases, the avoidance of losses and terrible years is more easily achievable than repeated greatness, and thus risk control is more likely to create a solid foundation for a superior long-term trackrecord.”

Related to the above, please see our previous articles on the concepts of “Toward vs. Away-From Motivation” and “Outer vs. Inner Scorecard.”