Investment legend Howard Marks says recognizing and dealing with risks associated with ups and downs of market cycles and knowing our position in these cycles are two key ingredients required for becoming a successful investor.
There are different cycles that influence financial markets, ranging from macro economy to credit, investor sentiment and what not.
These different cycles feed into market cycle and you can spot great opportunities by observing these cycles keenly.Study history, economy investor psychology to withstand market volatilityMarks, co-chairman and co-founder of Oaktree Capital Management, believes risk can be minimised near market peaks and bottoms by studying how economy, markets and investor psychology move in long cycles of expansion and contraction.Marks recommends investors to look at recent history, human emotion and asset pricing to be better equipped to interpret volatility of market cycles, which can help bring clarity to investment decisions.But he warns that while recent performance can only tell something about longer-term probabilities or tendencies, they but cant be relied upon for short-term projections.Know your position in market cycleMarks says one of most important priorities for an investor should be to know his position in market cycle.
By doing things like reading widely and doing right research, it is possible to see patterns that can inform an investor about current state of a market cycle even though they cant predict precisely when it will shift in short term.
By performing this exercise, investors can increase their margin of safety and get odds on their side.Marks believes right way to predict where market cycle might be is to think probabilistically.While they may not know what lies ahead, investors can enhance likelihood of success by basing their actions on a sense for where market stands in its cycle there is no single reliable gauge that one can look at for an indication of whether market participants behaviour at a point in time is prudent or imprudent.
All we can do is assemble anecdotal evidence and try to draw correct inference from it, Marks points out in his latest books promotional video, which is now available on YouTube.Make risk calibration a priorityAccording to Marks, key to an investment decision is to calibrate risk, as investors tend to think in binary terms.
The amount invested, allocation of capital among various possibilities, and riskiness of things you own all should be calibrated along a continuum that runs from aggressive to defensive, he feels.Stand against herdMarks says when economic and corporate outlook looks bright and prices are going up every day, investors want to go out and buy more due to rising optimism and euphoria.He stresses that this excessive optimism can be dangerous.
Risk aversion is an essential ingredient for market to be safe, says he.
An overly generous capital markets can ultimately lead to unwise financing.When prices are high, investors should want to sell and not buy.
Very few investors follow this principle because they feel very positive about outlook.
Similarly, when prices hit rock bottom investors are most depressed and most unlikely to buy.Marks advises investors to do opposite and stand against herd.
We must stand against mass psychology.
We must sell when fundamentals are at their peak and emotions are most positive, and we must buy when fundamentals are at trough and people are most depressed, he asserts.According to him, goal should be to buy low and sell high.
More people buy high than buy low.
You have to understand what's wrong about it, and you must be able to stand against it, he feels.Investor psychology key influencer of marketsMarks believes there is a reason why swings of stock market far exceed swings in corporate earnings.
This, he feels, is due to investor psychology, which he compares to swing of a pendulum.Mostly, a decline in stock market is more due to human emotion than due to excel spreadsheets, discount rates or profits.
Human beings are inherently emotional beings, who have psychological impulses that cause massive overreactions in many facets of life.
This is certainly true in stock market and this creates massive swings totally disconnected from fundamentals.
Human beings like to create narratives to explain what is often unexplainable, he observes.(Disclaimer: This article is based on various videos of Howard Marks available on YouTube and his recently launched book Mastering Market Cycle: Getting Odds on Your Side)