I recently re-read Howard Marks' seminal book about risk and psychology, The Most Important Thing. (If you read it I would recommend the original version, not the 'illuminated' version with editorial commentary).
So what is 'the most important thing' about investing? Actually, there are about 20 'most important' things that Marks discusses, but I found that the book focuses on 3 main areas:
- It is vital to have a strongly held view of intrinsic value
Without a strongly-held view of what something is worth, investors will find themselves at the prey of the market, and find themselves buying at the top of the market, or selling at the bottom – the two worst things you can do in investing. With a view of intrinsic value, it is possible to be contrarian by buying when others are avoiding a business, and sell when they are clamouring to buy it.
- Price and risk are two sides of the same coin
Marks defines investment risk as the 'risk of permanent loss'. But he also makes an explicit link between price and risk by pointing out that higher prices also increase risk, because they narrow the range of outcomes that can occur before you see a loss.
Put it this way, would you buy shares in TPG Telecom Ltd (ASX: TPM) for $7 today? Why not? Obviously, because they are only selling for $5.04 right now.
Yet if you were convinced that they were worth $10 – remember the first dot point about intrinsic value – wouldn't $7 be a fair price to pay? Perhaps it would, but fewer things can go wrong before shares fall below $7, compared to if you'd bought at $5. A lower price can give what Marks called a 'margin of safety'.
- Everything moves in cycles
In Australia, we should know this better than anybody, given our mining and banking-dominated economy. Yet it's easy to forget in the midst of a 10+ year boom that things can go awry. Commonwealth Bank of Australia (ASX: CBA) profits don't climb forever. Debt is not always available freely and cheaply. China may not always consume a billion tonnes of Rio Tinto Limited's (ASX: RIO) iron ore every year. The most important thing is to be able to 'stay in the game' by containing losses during a downturn, notably by avoiding risky debt.
If you're new to investing and want to learn more about how to preserve your funds and not take too much risk, Marks' book is a good place to start.
