With the stock market reaching all time highs, maybe it’s a good time to revisit Howard Marks’ memo of 2005 in which he discusses market trends being taken to excess – and the painful consequences that become clear in hindsight.
Here’s an except from that memo:
“The farther backward you can look, the farther forward you can see.”
– Winston Churchill
I often cite John Kenneth Galbraith’s observation that one of the outstanding hallmarks of the financial world is “the extreme brevity of the financial memory.” Investors lose money over and over because they simply forget that cycles are inevitable and there’s no such thing as a free lunch. Now I’ve found a great quotation from Churchill, also reminding us that foresight comes largely from awareness of history.
Along similar lines, I’m struck by the extent to which a related factor, inadequate skepticism, also contributes to investment losses. Getting the most out of a book, play or movie usually requires “willing suspension of disbelief.” We’re glad to overlook the occasional plot glitch, historical inaccuracy or physical impossibility because it increases our enjoyment. When we watch Peter Pan, we don’t want to hear the person sitting next to us say, “I can see the wires” (even though we know they’re there). While we know boys can’t fly, we don’t care; we’re just there for fun.
But our purpose in investing is serious, not fun, and we must constantly be on the lookout for things that can’t work in real life. In short, the process of investing requires a strong dose of disbelief. Time and time again, the post mortems of financial debacles include two classic phrases: “It was too good to be true” and “What were they thinking?” I’m writing to explore why these observations are so often invoked in the past tense.
The combination of greed and optimism repeatedly leads people to pursue strategies they hope will produce high returns without high risk; pay elevated prices for securities that are in vogue; and hold things after they have become highly priced in the hope there’s still some appreciation left. Afterwards, hindsight shows everyone what went wrong: that expectations were unrealistic and risks were ignored.
It is my point that:
Investors mustn’t dwell excessively on recent experience.
Instead, they must look to the future.
They must consider today’s developments critically.
That assessment must take place in the light of history’s lessons.
All too often, investors’ interest in the past is limited to the last few months or perhaps a year or two. They look unskeptically, are dazzled by the high returns they see, and jump aboard for more of the same. But they usually fail to consider longer-term history, which would show that “free lunches” never last forever. When the check ultimately comes in the form of losses, there’s surprise and disappointment that could have been avoided.
Time after time when I read about trends being taken to excess – and later, when the painful consequences become clear – I find myself asking what they could have been thinking. The alpha that’s so much in demand today is really the ability to see ahead to things others will see only afterwards, in the rearview mirror. The people of Oaktree spend a lot of their time figuring out what might be the next mistake and preparing for it. In other words, we try to anticipate – and avoid – pitfalls that others will rue after the fact.
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