Oaktree Capital Co-founder Howard Marks on Luck, Risk, and Avoiding Losers – The Knowledge Project

Check out the Knowledge Project Episode Page & Show Notes

Key Takeaways

  • If you make a mistake, don’t get down on yourself
    • Realize they happen, examine your process, and correct for the future
  • Oaktree Capital’s motto – “If we avoid the losers, winners take care of themselves”
  • You have a better chance of accomplishing that which you prioritize
    • With investing – “One of the reasons we’re so good at controlling risk, is because we put risk control first”
  • You cannot tell the quality of a decision from the outcome
    • Improbable things happen all the time, and probable things fail to happen all the time
  • Here’s why market cycles occur:
    • “Cycles happen because people commit excesses to the upside, usually out of enthusiasm, which then have to be corrected, and those corrections overshoot to the downside”
  • The greatest contributor to global economic maximization
    • Globalization
  • More likely than not, luck plays a role in everyone’s successes
  • Self-driving cars will put a TON of people out of work
  • Risk is the probability of bad outcomes
    • Bad outcomes = loss AND gains that you miss out on
    • Many people care more about the former – we should think of risk in terms of BOTH
  • The earlier a child can learn that mistakes won’t kill them, the better

Books Mentioned and Recommended Reading

Intro

The 2008 Financial Crisis

  • The financial crisis grew out of excesses that were painfully corrected
    • The excesses included:
      • An excess of credulousness
      • Too much faith in mortgages and mortgage-backed securities which were invested too heavily and too riskily by several financial institutions
  • How Howard thought about investing his clients’ funds during the crisis:
    • “Anything you might do to prepare for the meltdown of the financial system would be a disaster under any other circumstances. And most of the time, the financial world doesn’t end.”
    • But should Oaktree continue investing?
      • If they continued to do so, and the financial system melted down – it wouldn’t matter anyway
      • But if they didn’t invest, and it didn’t melt down, they abdicated their responsibility (they were hired by their clients to invest)
      • So – they had no choice, they had to continue investing
        • “For the last 15 weeks of 2008, we invested an average of $650 million per week for a total of $10 billion”
        • And what do you know… the financial world didn’t end up melting down

Learn to Go Against Your Emotions

  • How did Howard and his team actually come to act on their decision to invest, despite the fire burning around them?
    • “It’s very difficult to make these contrarian actions in the face of sentiment”
    • “Our emotions conspire at every turn to make us do the wrong thing”
      • When financial markets are good – emotion causes people to buy more
      • When financial markets/prices cascade down – people get depressed, and exit the markets due to a fear of losing more
    • In his book, Howard quoted Richard Feynman – “Physics would be much harder if electrons had feelings”

There’s No Such Thing As Markets

  • “There’s no such thing as markets, there’s only a bunch of people who trade”
    • “A market consists of a group of people who implement their views on value by transacting”
    • “All there is, is people, who have feelings”

How was Howard able to deal with the ’08 crash so well?

  • You rehearse and learn from experience:
    • There was a market downturn in ’90-’91and another in ’01-’02
  • “At some point, our intellect, aided by dispassionate observation of experience, can overcome our emotion”
  • Howard describes himself as “less emotional than most”
  • Howard says of him and his partner, Bruce Karsh:
    • “We are unusually supportive of each other”
      • Howard knows that his organization won’t make successful investments all the time – there are bound to be mistakes
      • “We are not a finger pointing organization”
    • “If you have a partner or organization that second guesses your mistakes, then you become mistake averse…and we don’t do that”

It’s All About Risk Control

  • On investing:
    • “I think we have an above average ability to detect risk and make investments that have upside potential, with the risks under control.”
      • “One of the reasons we’re so good at controlling risk, is because we put risk control first”
    • The motto of Oaktree – “If we avoid the losers, winners take care of themselves”
      • It’s all about risk control
  • It’s important to be able to distinguish between bad decisions vs. bad outcomes 
    • “You can’t tell the quality of a decision from the outcome”
    • Just know that – “Improbable things happen all the time, and probable things fail to happen all the time”
    • In the short run – a good decision that didn’t work, can look like a bad decision, however that may not be the case

Be Mellow Man

  • “We try to have a mellow organization. We try to hire people that are not that terribly emotional or egotistical, who don’t have a lot of hubris or testosterone.”
    • How does Oaktree test for this?
      • Just through conversation
      • It’s simple really – If you put a high priority on hiring non-reactive people, you have a better chance of doing so

Market Cycles

  • In the 70s there was runaway inflation in America (~16% a year)
    • “Inflation is very mysterious. It’s hard to say what starts it, it’s hard to say what stops it.”
  • On average, the U.S. economy grows 2% every year 
  • “Cycles happen because people commit excesses to the upside, usually out of enthusiasm, which then have to be corrected, and those corrections overshoot to the downside”
    • A simple example:
      • A company coming out of a recession, because of a speculated increased product demand, will build new factories and hire more people
        • (All companies in the same industry do this)
        • This results in an above average year in the economy
      • But collectively, more factories were built and more people were hired than needed to take advantage of the increased demand for the products
        • So they falter, and a below average year ensues
  • The US economy is currently in its 10th year of recovery after the 2008 recession
    • There’s NEVER been a recovery of more than 10 years – but this is not to say another crash is coming soon 
    • This has also been the slowest recovery since World War II
      • The Bad News – the slowness of recovery
      • But Good News – it hasn’t been marked by excesses
    • “My guess is that this recovery will set a record for the longest recovery in history because of the slowness and the absence of excesses”

A Real World Example

  • A recent tax bill in the U.S. was passed which was “highly stimulative” as it cut the tax rates of large corporations from 35% to 21%
    • Howard calls it “oversitmulative”
      • “Doctors don’t give adrenaline to healthy patients. They give it to patients having a heart attack.”
      • Howard thinks this tax bill will lead to excesses that then need to be corrected
    • And how do we correct excesses?
      • By raising interest rates (lowering interest rates has the opposite effect – it’s stimulative)
        • This increases the possibility of lapsing into recession

Specialization, Our Situation with China, and Tariffs

  • “The greatest contributor to global economic maximization is globalization”
    • Countries need to be able to do what they’re best at (specialize) and trade to get what they can’t produce/make internally
  • This is related to the U.S.’s current trade deficit of ~$800 billion with China
    • What’s a trade deficit?
      • This is similar to you going to get a haircut, and paying $15 for it – you’re now at a $15 trade deficit
    • So our trade deficit with China means we’ve bought ~$800 billion more of Chinese goods than they’ve bought of American goods
      • But this isn’t necessarily a bad thing… we’re getting lots of cheap goods that we don’t have to manufacture
    • The U.S. has lost 13 million jobs to China over the last 15 years
      • So, it’s been thought that in order to bring these jobs back to the U.S., we (the U.S.) should impose tariffs (taxes) on imported Chinese goods (thus, Americans would be required to pay higher prices on these goods)
        • Whether this is a good/bad trade off….is up to Washington
  • World economic product is maximized by globalization – it’s a winning strategy

Political Tribalization

  • Politics has turned into name calling, vilification of the other side, and tribalization of opinions
  • Both sides (Republicans and Democrats) can’t communicate, because they think differently
    • No one concedes weaknesses about their positions on certain topics – everyone just fights for their side

Howard’s Memos to Oaktree Clients

  • Shane is a huge fan of them
  • Check out this memo Hoard wrote in May 2016 – Economic Reality
    • To sum up: If you tax the rich heavily – they can just move out of the country/state
      • For example, you can “live” in Florida (which has a very low tax rate), and still live in NY for a maximum of 181 days per year 
  • Then there’s Political Reality – written in August 2016
  • Howard’s next memo is going to be about tariffs and all the things people don’t understand
    • A background example – if a tariff is placed on imported steel, it’s done to protect American manufactures of steel
      • But when this is done, American manufacturers of something like motorcycles (who use foreign steel) are at a disadvantage compared to those who use domestic steel
  • In January 2014, Howard wrote his most popular memo – Getting Lucky
    • Howard recalls someone in Silicon Valley saying – “Success is never accidental. You make your own luck.”
      • “I don’t agree. I think luck is a real thing and it’s important.”
        • Like your IQ – If yours is high, more likely than not, you were born with much of your intellectual ability
        • So acknowledge the luck in your life that got you to where you are, and be thankful for it
          • Cicero once said – “The thankful heart is not only the greatest of all the virtues, but it is the parent of all the other virtues”

Universal Basic Income (UBI)

  • “I do not want to see the unfortunate among us suffer”
  • The world has been doing quite well at fighting extreme poverty
  • A good point – “We get a lot more from our work than just our income” – like:
    • Self-satisfaction
    • The feeling of contributing to a greater good
    • Bonding over solving a problem
  • “Universal basic income will not give those benefits. It will only feed physical needs.”
    • Howard acknowledges that it would keep people out of poverty – “But it won’t solve the major problems of society” (e.g., automation and the elimination of jobs)
  • That being said – Howard recalls a great point from one ofJohn Kenneth Galbraith’s latest books (he doesn’t say which):
    • It’s ridiculous that we use the same word to describe what a CEO does and what a road worker does”

Technology and Automation

  • The timeline:
    • When farmers lost agricultural jobs due to automation, many of them moved into manufacturing-based roles to make cars/appliances…and everything was fine
    • But then manufacturing moved overseas
    • Now what do these people do? – It’s a big problem
  • More backstory:
    • The U.S. has, meanwhile, has become stronger in manufacturing
      • Since ~1979, our manufacturing output has doubled (we sell 2x as much as we did 40 years ago)
      • AND 40 years ago, the U.S. had ~19 million people working in manufacturing, but only 12 million today
        • So the output per worker has tripled
          • (compare this to the ~3 million jobs the U.S. has lost to China mentioned above)
  • Self-driving cars will put a TON of people out of work
    • Taxi drivers, limo drivers, Uber drivers, truck drivers
    • But also the people who work at body shops – there won’t be as many accidents
    • AND many of the people who work at insurance companies
    • Howard also speculates that many people won’t even own cars anymore
      • Rather – it will be similar to how it is with scooters/bikes in big cities (you’ll rent one as you need it)
  • But haven’t we faced this issue before? (described above)
    • Yes – but this time is different
      • Howard isn’t optimistic
      • More high skilled/computer skills are needed – many people don’t have these and/or can’t learn them
  • What will happen to wages during the automation revolution?
    • The people with technical/computer skills will do well, and those without, will do poorly

How does Howard define risk?

  • The probability of bad outcomes
    • Bad outcomes = loss AND gains that you miss out on
      • While people care more about the former – we should think of risk in terms of BOTH
  • Check out Risk Revisited Again– a memo Howard wrote in 2014
  • “Risk exists because the future is a range of possibilities” Peter Bernstein
    • Howard notes that sometimes we don’t even know what’s in the range of possibilities, let alone their respective probabilities 
  • “Risk means more things can happen than will happen” – Elroy Dimson
  • The concept of expected value is important:
    • This involves assigning probabilities to certain outcomes – you figure out which course of action has the highest probable weighted value
    • For example:
      • In poker, if you are faced with the decision of whether to fold or call a bet of $40…
      • If you call, you can win $100 – but you’re only expected to win 30% of the time
      • The expected value of calling is = $100 * 30% – $40 * 70% = $2
    • Try to view decisions in life through the lens of expected value

Second-Level Thinking

  • “If you think the same as everybody else, you’ll take the same actions as everybody else. If you take the same actions as everybody else, you’ll have the same performance as everybody else. This, by definition, can’t result in above average results. So you can’t think the same as everyone else; you have to diverge from the thinking of the herd at some point in time.”
    • To be an outperformer, you have to think differently from the crowd despite the crowd being correct most of the time
  • So… to be an above average investor:
    • You have to think differently from the crowd
    • AND you have to be right
  • Second order thinking = thinking different and better
    • “The way you become a superior investor is to look at things, and see other things people don’t see”
  • Examples:
    • A first-level thinker says – “This is a great company. We should buy the stock.”
      • The first-level thinker thinks simply
    • The second-level thinker says – “It’s a great company, but it’s not as great as everybody thinks. The opinions incorporated into the price are too optimistic. When the truth comes out, those hopes will be dashed and the price will fall, so we should sell the stock.”
      • The second-level thinker goes DEEPER – It’s contrarian thinking

How important is the ability to “look stupid”?

  • “It’s one of the most essential ingredients”
  • In 2006, Howard wrote a memo related to this titled Dare to be Great (It was updated in 2014 – Dare to Be Great II)
    • To be great, here’s what you need:
      • Dare to be different
      • Dare to be wrong
      • Dare to be stupid/look wrong

How does Howard go about thinking differently than everyone else? Does trying to do so change the information he consumes?

  • Here’s what he recommends. Stop and ask yourself:
    • “What do other people think?”
    • “Why do they think it?”
    • “Why do they diverge from me?”
    • “What makes me think I’m right and they’re wrong?”
  • It doesn’t really change what he consumes – “It just adds another level to the information”

How did Howard teach his kids about money?

  • He always made sure to talk about it with them and help them think through financial decisions
    • “You should not insulate your kids from the discussion of money”
  • Kids should understand that money is finite 
    • You’re not helping your kids if you give them a credit card and pay the bill for them every month
  • Another piece of advice for parents:
    • Let your child make more choices
    • “Insulating kids from choices (or making mistakes) is not doing them a favor”
      • They need to learn that mistakes won’t kill them

Wrapping Up

  • From Howard’s book – Mastering the Market Cycle: Getting the Odds on Your Side:
    • “Being wrong is inevitable and normal, not some terrible tragedy”
    • “Being wrong comes with the franchise of an activity who’s outcome depends on an unknown future”
    • If you make a mistake, don’t get down on yourself
      • Examine your process, and correct for the future

These notes were edited by RoRoPa Editing Services

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