Howard Marks, cochairman and cofounder of Oaktree Capital Management and author of The Most Important Thing, expands on one of his twenty “most important things” in Mastering the Market Cycle: Getting the Odds on Your Side (Houghton Mifflin Harcourt, 2018). Marks paints in broad strokes, so the reader will not come away from this book with any concrete trade ideas. But, after reading Marks’s analysis, he should better understand how to sync his portfolio with the ebb and flow of the market, so as not to buy at the top and sell at the bottom, even though “the tendency of people to go to excess will never end.”
Marks discusses multiple cycles that feed into the market cycle: the economic cycle, the cycle in profits, the pendulum of investor psychology, the cycle in attitudes toward risk, the credit cycle, the distressed debt cycle, and the real estate cycle. He also looks at the cycle in success. Of these, the one he considers most important is the risk cycle. So let me summarize some of his points on this front.
It is often set forth as a truism that, since there seems to be a positive relationship between risk and return (the ubiquitous upper-sloping line), “riskier assets produce higher returns” and hence “if you want to make more money, the answer is to take more risk.” This formulation, Marks explains, “cannot be true, since if riskier assets could be counted on to produce higher returns, they by definition wouldn’t be riskier.”
In general, of course, the capital market line, or risk/return continuum, makes sense if viewed in terms of rational expectations. We expect to make a higher return on investments in small cap stocks than on investments in money market funds, and the former is perceived to be proportionally riskier than the latter. On this continuum “there won’t be particular points … where risk-bearing is rewarded much more or much less than at others (that is, investments whose promised risk-adjusted return is obviously superior to the rest).”
But fluctuations in attitudes toward risk can upset this continuum. As investors become increasingly optimistic, even euphoric, they are willing to settle for skimpy risk premiums on risky investments. “This reduced insistence on adequate risk premiums causes the slope of the capital market line to flatten.” And so, Marks writes, “risk is high when investors feel risk is low. And risk compensation is at a minimum just when risk is at a maximum.” At the other end of the spectrum, when markets sell off, investors become excessively risk averse, and the slope of the capital market line increases, offering “an exaggerated payoff for risk-bearing. Thus the reward for bearing incremental risk is greatest at just the moment when—no, rather, just because—people absolutely refuse to bear it.”
When should investors begin to buy as the market is cascading downward? Marks strongly rejects the idea of waiting for the bottom. First, there’s no way to know, except in hindsight, when the bottom has been reached. “And second, it’s usually during market slides that you can buy the largest quantities of the thing you want, from sellers who are throwing in the towel and while the non-knife-catchers are hugging the sidelines. But once the slide has culminated in a bottom, by definition there are few sellers left to sell, and during the ensuing rally it’s buyers who predominate.” So, to repeat, when should investors start to buy? For Marks, the answer’s simple: buy when price is below intrinsic value. And if price continues downward, buy more. “All you need for ultimate success in this regard is (a) an estimate of intrinsic value, (b) the emotional fortitude to persevere, and (c) eventually to have your estimate of value proved correct.”