What are the key messages?
The second chapter introduces us to the theories behind finance and investing, a body of thought known as the “Chicago School” because of its origins at the University of Chicago.
“The theory included concepts that went on to become important elements in investment dialogue: risk aversion, volatility as the definition of risk, risk-adjusted returns, systematic and nonsystematic risk, alpha, beta, the random walk hypothesis and the efficient market hypothesis. The last one being specially important because of its influence.
“The efficient market hypothesis states that:
There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed.
Because of the collective efforts of these participants, information “is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other.
Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.
Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are “fair” relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no incremental return that is not related to (and compensatory for) incremental risk.”
#Howard Marks offers a more practical take on this theory…
“I also use the word efficient, but I mean it in the sense of “speedy, quick to incorporate information,” not “right”…because investors work hard to evaluate every new piece of information, asset prices immediately reflect the consensus view of the information’s significance. I do not, however, believe the consensus view is necessarily correct”
In January 2000, Yahoo sold at $237. In April 2001 it was at $11. Anyone who argues that the market was right both times has his or her head in the clouds; it has to have been wrong on at least one of those occasions.”
#Howard Mark makes an important distinction, where information may be quickly assimilated but the consensus views that develop may not always be correct. Thereby creating market inefficiencies.
“If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold an idiosyncratic, or non consensus, view.”
#Howard Mark again asks us to incorporate second level thinking to take advantage of market inefficiencies.
“it’s not easy for any one person—working with the same information as everyone else and subject to the same psychological influences—to consistently hold views that are different from the consensus and closer to being correct.”
“Seth Klarman: Psychological influences are a dominating factor governing investor behavior. They matter as much as—and at times more than—underlying value in determining securities prices.”
“One of the greatest ramifications of the Chicago theory has been the development of passive investment vehicles known as index funds.”
“The most important upshot from the efficient market hypothesis is its conclusion that “you can’t beat the market.”
“Because theory says in an efficient market there’s no such thing as investing skill (commonly referred to today as alpha) that would enable someone to beat the market, all the difference in return between one investment and another—or between one person’s portfolio and another’s—is attributable to differences in risk.”
“we experience periods when everything goes well and riskier investments deliver the higher returns they seem to promise. Those halcyon periods lull people into believing that to get higher returns, all they have to do “is make riskier investments.”
#HM does not think this is true and investors are often given a rude lesson when riskier assets cause permanent losses.
“In fact, some asset classes are quite efficient. In most of these:
-the asset class is widely known and has a broad following;
-the class is socially acceptable, not controversial or taboo;
-the merits of the class are clear and comprehensible, at least on the surface; and
-information about the class and its components is distributed widely and evenly.”
“If these conditions are met, there’s no reason why the asset class should systematically be overlooked, misunderstood or underrated.”
“Paul Johnson: Inverting these conditions yields a test of market inefficiency. For instance, in the first case, if an asset is not widely known and broadly followed, it might be inefficiently priced; in the second case, if an asset is controversial, taboo, or socially unacceptable, it might be inefficiently priced; and so on for each of the other two cases.”
Howard Mark introduces us to some conditions under which inefficiencies may get reflected.
“With millions of people doing similar analysis on the basis of similar information, how often will stocks become mispriced, and how regularly can any one person detect those mispricings?
Answer: Not often, and not dependably. But that is the essence of second-level thinking.”
“Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both. They are on the alert for instances of misperception”
In making an investment thesis he urges to ask “And who doesn’t know that?"
This is the essential message, second level thinking requires informational edge or analytical edge or both. Implied also is the “behavioural edge”.
He also urges us to create a variant view that might help build a non consensus thesis.
“A market characterized by mistakes and mispricings can be beaten by people with rare insight. Thus, the existence of inefficiencies gives rise to the possibility of outperformance and is a necessary condition for it. It does not, however, guarantee it.”
“Inefficient markets do not necessarily give their participants generous returns. Rather, it’s my view that they provide the raw material—mispricings—that can allow some people to win and others to lose on the basis of differential skill.”
“In the great debate over efficiency versus inefficiency, I have concluded that no market is completely one or the other. It’s just a matter of degree.”
“I believe strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there”
“Paul JohnsonMarks’s observation is that investors should look for markets or assets that are not fully efficiently priced rather than chase after the false god of completely inefficient markets.”
“Bottom line: Inefficiency is a necessary condition for superior investing. Attempting to outperform in a perfectly efficient market is like flipping a fair coin: the best you can hope for is fifty-fifty. For investors to get an edge, there have to be inefficiencies in the underlying process—imperfections, mispricings—to take advantage of.
“…let’s say there are. That alone is not a sufficient condition for outperformance. All that means is that prices aren’t always fair and mistakes are occurring: some assets are priced too low and some too high. You still have to be more insightful than others in order to regularly buy more of the former than the latter. Many of “the best bargains at any point in time are found among the things other investors can’t or won’t do.”
“Joel Greenblatt: This is very important and helps explain why most professionals have a hard time beating the market. Investments that are out of favor, that don’t look so attractive in the near term, are avoided by most professionals, who feel they need to add performance right now.”
“The key turning point in my investment management career came when I concluded that because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.”
Howard Mark urges us to look for pockets of inefficient markets where an investor can create an edge.
“theory should inform our decisions but not dominate them. If we entirely ignore theory, we can make big mistakes. We can fool ourselves into thinking it’s possible to know more than everyone else and to regularly beat heavily populated markets. But swallowing theory whole can make us give up on finding bargains, turn the process over to a computer and miss out on the contribution skillful individuals can make.”