Notes for “The Most Important Thing Illuminated： Uncommon Sense for the Thoughtful Investor”

Author: Howard Marks

Chapter 1: Second-Level Thinking

1. Investment methods must rely on intuition and continuous adaptation, not fixed or mechanized operations.
2. Definition of successful investment: Outperforming the market and other investors.
3. First-level thinking would say, “This is a good company, so buy.” Second-level thinking would say, “Everyone thinks this is a good company, leading to an overvalued stock, hence sell.”

Chapter 2: Understanding Market Efficiency (and Its Limitations)

1. Because investors diligently evaluate each piece of new information, asset prices rapidly reflect the market’s consensus on the importance of these messages. However, consensus isn’t always correct.
2. Taking risks doesn’t always lead to returns.
3. To achieve outstanding performance: Informational advantage, analytical edge.
4. When returns seem disproportionately high relative to risk, does it imply overlooking some hidden risks?
5. Focusing on inefficient markets leads to favorable returns.

Chapter 3: Value

1. Buy at a price lower than the intrinsic value and sell at a higher price.
2. Value investing aims to identify the current value of securities and buy when the price is lower than its value. It doesn’t require predicting the future but seeks sustained increases.
3. Growth investing identifies stocks with expected rapid future value growth. It requires predicting the future and looking for big winners.
4. Even if your perspective in the investment world is correct, immediate validation isn’t guaranteed.
5. Distinguishing between being ahead of the times and failure is challenging.
6. Elements for profit in a declining market: Having a personal view of intrinsic value, being right, and remaining steadfast.

Chapter 4: The Relationship Between Price and Value

1. No matter how good an asset is, buying at too high a price can turn it into a poor investment, while it’s rare that buying at a sufficiently low price isn’t a good investment.
2. Buying stocks from forced sellers is the best thing, while becoming a forced seller is the worst.
3. Investment is a popularity contest, and the most dangerous thing is buying when it’s most popular. The safest and potentially most profitable investment is buying when nobody likes it.
4. Intrinsic value is only one of the factors determining security prices; you should also try to use fundamental and technical skills.
5. Using leverage doesn’t turn anything into a good investment or increase the probability of profit; it only amplifies profit or loss.

Chapter 5: Understanding Risk

1. Investment is all about dealing with the future.
2. Understanding, evaluating, and controlling risks.
3. Higher risks should provide higher potential returns, but potential returns may not materialize.
4. The most important risk is the possibility of losing money.
5. Prudent value investors believe that buying below value can achieve both high returns and low risk.
6. Skillful investors focus on the stability and reliability of value and, relationship between price and value.
7. Risk means there are more possibilities than what is about to happen.
8. There’s a significant difference between probability and outcome: Things that might happen might not, and things that can’t happen sometimes do.
9. Returns don’t explain investment quality; risk should be considered, but it’s immeasurable.
10. Risk is solely about the future, and we cannot precisely know how the future will be. When we look back, we know something happened because only one thing happened, making us underestimate the existence of variability and the possibility of other events.

Chapter 6: Recognizing Risk

1. It’s widely believed that where there’s no risk, there’s rarely high risk. Only when investors appropriately mitigate risk can expected returns include an appropriate risk premium.
2. Risk implies uncertainty, along with the possibility of loss when adverse situations occur.
3. Risk cannot be eliminated, only transferred and diversified.
4. The market isn’t a static space controlled by investors; it reshapes based on investor behavior.
5. Perversity of risk: Increased investor confidence creates risk (prices), while increased fear and risk aversion decrease risk (prices) while increasing risk premiums.
6. Risk comes from purchase prices, not quality.

Chapter 7: Controlling Risk

1. Even when losses haven’t occurred, risks might still exist. Bull markets can still control risks.
2. An investor’s job is to smartly take risks for profits, and the best test is whether there’s a consistent record of success in the long term.
3. In bear markets, the value of risk control is evident in reduced losses, but the cost of risk control (foregone returns) appears high. In bull markets, risk-aware investors profit from controlling portfolio risks, even if risk control may not seem necessary.
4. The major investment line is in not knowing how bad situations can be, leading to poor decisions.
5. Controlling and avoiding risks are different. Controlling risk is the best way to prevent losses. Conversely, avoiding risk might also avoid returns.
6. An investor’s lifelong investment outcome depends on how many failed investments and how severe those failures are, rather than how successful their investments are.

Chapter 8: Being Attentive to Cycles

1. Rule one: Most things have cycles.
2. Rule two: When others forget to rule one, that’s when the greatest opportunities for profit and loss arise.
3. Cycles arise from human involvement: People are emotional, inconsistent, neither steadfast nor objective.
4. Cycles self-correct and can reverse without external factors; trends create reasons for cycle reversals. Success itself carries seeds of failure, and failure carries seeds of success.
5. Credit cycle flow
6. Trees don’t grow straight into the sky, and very few things have values that drop to zero; most phenomena exhibit cyclical changes.

Chapter 9: Awareness of the Pendulum

1. The time the pendulum stays at the midpoint is short; most of the time, it swings back and forth toward the high points on both sides, but it eventually returns to the midpoint. In fact, swinging toward the high points is what provides the impetus for the pendulum to reverse. This oscillation is one of the most reliable features in investing, yet investors often spend too much time at both extreme high points.
2. There are two types of risks: the risk of loss and the risk of missing opportunities. During bullish times, investors worry more about missing opportunities, whereas during bearish times, they worry more about the risk of loss.
3. Bull Market Phase One: A few visionary individuals believe things will get better.
4. Bull Market Phase Two: Most investors understand that the situation is improving.
5. Bull Market Phase Three: Everyone believes things will continually improve.
6. Bear Market Phase One: Despite general optimism, a few investors believe things won’t always get better.
7. Bear Market Phase Two: Most investors recognize that things are deteriorating.
8. Bear Market Phase Three: Everyone believes things will only get worse.
9. Everything influences each other; nothing is an isolated event that happens by chance.
10. The speed and strength of swinging from high points in the opposite direction are rapid; deflating a balloon is much quicker than inflating it.
11. Collapse is a byproduct of prosperity, and I believe attributing a collapse to previous excessive prosperity, rather than specific events causing a market correction, is usually more accurate.

Chapter 10: Combating Negative Influences

1. When others make mistakes, it creates market inefficiencies and provides opportunities for outstanding returns, but you must be on the correct side.
2. Many people reach similar analytical conclusions but take vastly different actions due to different psychological influences.
3. Error in mindset one: Greed. When greed combines with optimism, it overpowers common sense.
4. Error in mindset two: Fear.
5. The general population easily disregards logic, history, and long-standing norms.
6. Error in mindset four: Herd mentality.
7. Error in mindset five: Envy.
8. Error in mindset six: Arrogance. Bulls aim for stable returns, bears reduce losses, and avoid risk because they know there’s still much they don’t understand.
9. Error in mindset seven: Surrender. When overpriced stocks keep rising, investors should sell, but they don’t; a mix of self-doubt and others’ success creates a powerful force leading to investor mistakes.
10. Accept that others might view your market perception as wrong; seek support from like-minded friends and colleagues.

Chapter 11: Contrarianism

1. We must resist trends, which is the market consensus.
2. Doing the same things as others exposes you to market fluctuations and sometimes magnifies them due to others and your actions.
3. Extreme situations created by the majority are mostly wrong. Only investors who confirm others’ mistakes and engage in contrarian investing reap significant benefits.
4. Public opinion behind an investment can easily diminish its profit potential.
5. Only when the majority fail to see the investment value does the market price fall below its actual value.
6. Successful investors are mostly solitary.
7. When facing the future, we must consider what might happen and the probability of those occurrences.
8. Don’t pick up a falling knife. By the time the dust settles and uncertainty is resolved, the cheapest opportunities for profit are gone. The most profitable investments often start with discomfort.

Chapter 12: Finding Bargains

1. Principle: Buy the best investments, sell off the poor ones, and reserve positions for the best investments; keep a distance from the worst investments.
2. Method: List potential investment targets, estimate their true value, compare the actual and current prices, understand the risks, and consider their impact on the investment portfolio.
3. Investing is the practice of relative decision-making. We can’t change the market; we can only select the best investment targets among available choices, which is relative decision-making.
4. The goal isn’t good assets; it’s good prices.
5. What assets tend to have lower prices? Those with objective drawbacks, based on incomplete information, disliked commodities are easily overlooked.
6. Most people use past trends to predict the future instead of relying on more reliable methods like regression to the mean. Those who think superficially tend to see high prices as good instead of a signal that assets are becoming cheaper.
7. Necessary conditions for bargain investments: little-known or misunderstood, fundamental doubts, controversy, deemed unsuitable for ‘standard’ portfolios, poor historical returns, recently targeted for reductions.

Chapter 13: Patient Opportunism

1. You’ll do better if you wait for investment opportunities rather than chasing them after they’ve appeared. Choosing buying targets from a seller’s increased offerings rather than fixed ideas about certain targets leads to better results.
2. The typical definition of impermanence is understanding the wheel of Dharma’s rotation, accepting inevitable fluctuations and changes. The past shapes our current situation; all we can do is understand it and make the best decisions under these specific conditions.
3. Missing investment opportunities is less regrettable compared to failed investments.
4. In a relatively low-return market, insisting on high returns is foolish. The investments that generate high returns are precisely when expected returns are lowest. The returns received for the risks taken are historically minimal.
5. Buying assets forced to be sold yields the highest returns.
6. Reasons for forced sales: funds facing redemption pressure, asset portfolios not meeting investment regulations, or contractual requirements.
7. Investors must adhere to the following: believe in value, use little or no leverage, possess long-term funds, and have strong patience.

Chapter 14: Knowing What You Don’t Know

1. The narrower our focus, the more likely we are to gain a knowledge advantage. “Knowing what you’re capable of knowing.”
2. There are two kinds of prophets: the ignorant and those unaware of their ignorance.
3. Investors should strive to know which phase they are in within the cycle and where the pendulum stands.
4. Being correct in expectations doesn’t always yield benefits: If you expect things to remain unchanged, this expectation won’t make you much money. But accurately predicting market changes can bring substantial profits.
5. Most speculations rely on extrapolation: These economists are like many prophets, looking in the rearview mirror while driving, telling us where things are, not where they’re headed.
6. Predicting the future based on the past is usually correct, but when the future resembles the past too much, it’s unlikely to yield significant gains. Occasionally, when the future differs greatly from the past, accurate predictions hold immense value, yet they are the most challenging. Overall, the value of predictions is minuscule.
7. Those who know the future should take directional bets, while those who don’t should diversify risks, avoid leveraging, and maintain a robust capital structure. The former often performs well before a crash, while the latter performs better after a crash. Those who don’t know the future but act as if they do bear opportunity costs, while those who do know but act as if they don’t are reckless.

Chapter 15: Having a Sense for Where We Stand

1. Remain vigilant during extreme market conditions.
2. Even if we can’t predict the timing and extent of cyclical changes, it’s important to make efforts to determine where we stand in the cycle and act accordingly.
3. Those who forget the past are destined to repeat it.
4. Understanding the impact of everyday events on market participants’ attitudes and the investment environment: Is funding easily available or not in the credit cycle? Is the P/E ratio at historical highs or lows? Are there significant differences in dividend yields?
5. Too much money chasing too few trades: If you want others (banks) to seek you out instead of funding competitors, you must make your money cheaper, like lowering interest rates.

Chapter 16: Appreciating the Role of Luck

1. The key to profits lies in aggressiveness, timing, and skill. When the timing is right, a sufficiently aggressive person needs minimal skill to succeed.
2. Every investment record should consider alternative outcomes, akin to alternative history, as easy to imagine as visible history.
3. At any given market time, the most profitable traders are usually those most adaptable to cycles.
4. In times of prosperity, the most profitable individuals are usually those taking the most risks, but that doesn’t necessarily make them the best investors.
5. Few fully comprehend the contribution and destruction that randomness brings to investors, often overshadowing the crises hidden within seemingly successful strategies.
6. Investors often make correct decisions for the wrong reasons.
7. The correctness of a decision cannot be judged by its outcome, but that’s how most people measure it.
8. Ample, long-term data is crucial in judging an investor’s ability.
9. What truly happens is just a fraction of what could happen.
10. Random events have the power to reward unwise decisions and punish good ones.
11. Defensive investments: Surviving in adverse conditions, not maximizing returns in favorable conditions.

Chapter 17: Investing Defensively

1. Seeking to hit winning shots in mainstream stock markets is unlikely to profit investors; they should aim to avoid making mistakes.
2. Approach risk with respect, view the future as a probability distribution, embrace defensive investments, and emphasize avoiding investment pitfalls.
3. Few can adapt tactics to market conditions, so investors should stick to a method that can apply to various situations. Oaktree Capital outperforms in bear markets, and that’s the most crucial thing during those times.
4. Defensive investment seeks high returns by avoiding losses, not by increasing returns. Firstly, exclude poorly performing assets from the portfolio, employ strict stock selection criteria, demand lower prices to set higher margin of error, and refrain from betting on sustained optimism. Secondly, avoid bear markets, especially those on the verge of a collapse, diversify assets, and limit overall risk exposure.
5. Portfolio safety should be determined by how much potential return one is willing to forgo; there’s no right answer, only trade-offs. Ensuring survival in adversity and maximizing returns in bull markets are conflicting strategies; investors must choose one.
6. Negative art: Distinguish whether you’re a bond investor not by how many interest-paying bonds you hold but by how many non-interest-paying bonds you exclude.
7. Aim for an average hit rate, not just home runs.
8. The best investors: Fearful of investment, demand high value with a realistic margin of error, aware of what they don’t know and can’t control.
9. Defensive investing: Fearful of investment.

Chapter 18: Avoiding Pitfalls

1. Failure of Imagination: Inability to conceive all potential outcomes or fully understand the ramifications when more extreme situations arise. Few understand asset correlation, how one asset’s change can cause chain reactions in another asset.
2. Low-risk portfolios may underperform the market during bull phases, but bankruptcy is unlikely, and the distance from the most dire fate is far.
3. Avoiding investment pitfalls is essential, but there must be a limit; this limit varies for each investor.
4. Lesson one from the credit crisis: Easy fund access leads funds to flow into the wrong places.
5. Lesson two from the credit crisis: When funds go where they shouldn’t, bad things happen.
6. Lesson three from the credit crisis: When there’s an oversupply of funds, investors vie for trades, accepting low returns and smaller margin for error.
7. Lesson four from the credit crisis: Easy fund access leads funds to flow into the wrong places.
8. Lesson five from the credit crisis: Ignoring risk commonly generates greater risk.
9. Lesson six from the credit crisis: Inadequate due diligence leads to investment losses.
10. Lesson seven from the credit crisis: When there’s an abundance of funds, funds flow into startups, many of which don’t survive the test of time.
11. Lesson eight from the credit crisis: Entire portfolios have fault lines running through them; seemingly unrelated assets create price correlations.
12. Lesson nine from the credit crisis: Psychological and technical factors often overshadow fundamentals.
13. Lesson ten from the credit crisis: Market changes render existing profit models ineffective.
14. Lesson eleven from the credit crisis: Leverage amplifies results but doesn’t add value.
15. Lesson twelve from the credit crisis: Overcompensation, excessive optimism.
16. These eleven points can be summarized: Be aware of the investment supply and demand scenario around you, as well as the eagerness to spend this money.
17. Before a crisis erupts, investors should pay attention to thoughtless, rash behavior by others, be mentally prepared for market reversals, sell assets, or at least high-risk assets, reduce leverage, increase cash positions, and fortify the defensiveness of their investment portfolios.
18. Counter-cyclicality: Surviving during recessions and buying at low points are the best formulas for success. Remember to avoid investment pitfalls!

Chapter 19: Adding Value

1. Alpha: Performance generated excluding market fluctuations.
2. Beta: Portfolio sensitivity relative to the market. Increasing beta increases returns but doesn’t increase risk-adjusted returns. The focus remains on risk-adjusted returns.
3. It’s not about how much return you get but how much risk you take to get those returns.
4. Skillful offensive investors: Make a lot during bull times, lose less than the market during bear times.
5. Skillful defensive investors: Don’t lose much during bear times, gain reasonable profits during bull times.
6. Style Adjusting: The real issue is how they perform when their long-term style doesn’t match environmental conditions.
7. During bull times, aim for average returns (rely on beta).
8. During bear times, beat the market (rely on alpha).

Chapter 20: Reasonable Expectations

1. Cheap doesn’t necessarily mean it won’t keep dropping. Low prices don’t guarantee an upcoming rise.
2. Most of the time, seeking single-digit or below double-digit returns is reasonable. 16% to 19% is highly exceptional.
3. Consistently pursuing perfection in investing usually yields no reward.
4. Dismissing market timing: Lack of interest in the market implies a greater emphasis on whether prices are cheap. Buying when you find attractive targets, not waiting for them to get cheaper six months later (market).

Chapter 21: Pulling it all together