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Howard Marks: market cycles, risk as the chance of loss and second-level thinking

Investment ideas Ideas explained with data from the portfolios of six investors

The co-founder of Oaktree Capital is known for memos that investors read around the world. His view of risk, of cycles and the pendulum of mood, and what it means for a patient investor.

Who he is

Howard Marks (born 1946) is an American investor. He worked at Citibank and at TCW before he co-founded Oaktree Capital Management in 1995 with a small group of colleagues. Oaktree became one of the best-known managers of credit, including the debt of troubled companies, and was later bought by Brookfield. Marks is better known to the public for his writing than for any single trade: for decades he has sent clients memos on markets, and they are read far beyond the clients.

He published two books: The Most Important Thing (2011), a set of short chapters on the ideas he returns to, and Mastering the Market Cycle (2018), on cycles. Buffett is among the well-known admirers of the memos.

The core ideas

The first is a definition of risk. For Marks, risk is not volatility, the number that most textbooks use, but the possibility of a permanent loss of money. Volatility is only a problem if you are forced to sell. And risk is mostly invisible: if nothing bad happens, you cannot tell whether the portfolio was safe or lucky. He adds that risk is greatest when it seems smallest, because when everyone is comfortable, prices are high and nobody is prepared.

The second is second-level thinking. A first-level thinker says that a company is good and so its shares should be bought. A second-level thinker asks what everybody else already thinks, what is already in the price, and what could be different from the consensus. To do better than the market you have to think differently from it, and be right. For that reason Marks stresses the price you pay: a great company can be a bad investment if it is bought at too high a price.

The cycles and the pendulum

Marks argues that most things in economics and markets are cyclical: they go too far in one direction and then return. He often writes that the greatest opportunities for gain and for loss come when people forget this. In his picture, investor mood swings like a pendulum between greed and fear, optimism and gloom; it spends little time at the sensible middle and often overshoots at the ends. When the mood is euphoric, risk is being taken for little reward, and when it is despairing, good assets can be sold for too little.

He pays particular attention to the credit cycle. When lenders are eager, weak borrowers get money and the standards fall, and the losses come later; when lenders are frightened, even good borrowers cannot get funds. He does not claim to forecast the turns. His point is more modest: you cannot know where the market is going, but you can try to judge where in the cycle it stands, and adjust how defensive or aggressive you are.

What six current portfolios show

A filing shows only listed US stocks, and Marks works mostly in credit, so none of the six portfolios is his. The nearest in spirit is Klarman's Baupost, a value investor who also holds a lot outside stocks. What the table does show is how different the answers to risk can be. Klarman's 23 positions behave like 13.4 equal positions, Buffett's 26 like 8.1, and Pabrai's 4 have the largest at 43.3% of the book. Berkshire changes about 1.0% of its book per quarter and Duquesne 23.8%.

None of these numbers measures risk in the sense of Marks. A concentrated book of cheap, sound companies can be less likely to lose money permanently than a broad book bought at high prices, and the table cannot tell you which is which, because it does not show prices paid, cash held or the debts of the companies. This is a good example of his point that risk cannot be read from a statistic.

Six real portfolios side by side, from the latest filing of each investor (Form 13F, US-listed stocks only). Effective positions is the number of equal-sized positions that would be as concentrated as the real portfolio: one divided by the sum of the squared shares. Opened or closed is the average over the four quarters of half the combined share of positions that were opened or closed.

Where it is challenged

The most common criticism is that there is no formula. Second-level thinking and a feel for the cycle cannot be tested in a spreadsheet, and the lessons are easier to see after the fact than before. Marks himself admits that he cannot predict the turns, and a contrarian who is early is, for a while, indistinguishable from one who is wrong. Academics prefer volatility as a measure of risk exactly because it can be measured, and note that for anyone who uses leverage or must make withdrawals, a temporary fall can become a permanent loss.

His own field, the debt of troubled companies, needs expertise and access that private investors do not have, so part of the lesson is hard to copy. And a wise saying such as 'most things are cyclical' does not tell you when to act.

What to take from it

Ask what is already in the price before you ask whether the company is good. Judge where the mood stands: when everybody is relaxed, think about what could go wrong, and when everybody is afraid, think about what is cheap. Prepare for the range of outcomes instead of predicting one. Do not borrow so much that a fall forces you to sell. And remember that surviving a bad period is worth more than winning a good one.

This is a description of a way of thinking, not a recommendation to buy or sell anything.

Where it meets our bots

Several bots follow the spirit of preparing instead of predicting. The permanent portfolio splits money among stocks, long bonds, gold and cash so that it does not depend on a forecast of which environment comes next. The volatility-targeting bot reduces its position when markets begin to swing widely, a mechanical way of cutting risk when risk shows itself. The 60/40 bot is the classic balance of growth and caution. The Models section shows published portfolios of this kind side by side.

Our trend bots do the opposite of a contrarian: they follow the market and leave when it turns down. Neither approach is right in every cycle, and the public accounts let you see how each one behaved. The guides below explain every rule.

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