Wednesday, June 25, 2014

Howard Marks on skepticism

The global credit crisis of 2007– 2008 represents the greatest crash I have ever seen. The lessons to be learned from this experience are many, which is one reason I discuss aspects of it in more than one chapter. For me, one such lesson consisted of reaching a new understanding of the skepticism required for contrarian thinking. I’m not usually given to epiphanies, but I had one on the subject of skepticism. 
Every time a bubble bursts, a bull market collapses or a silver bullet fails to work, we hear people bemoan their error. The skeptic, highly aware of that, tries to identify delusions ahead of time and avoid falling into line with the crowd in accepting them. So, usually, investment skepticism is associated with rejecting investment fads, bull market manias and Ponzi schemes. 
It was readily apparent immediately after the bankruptcy of Lehman Brothers that . . . a spiral was under way, and no one could see how or when it might end. That was really the problem: no scenario was too negative to be credible, and any scenario incorporating an element of optimism was dismissed as Pollyannaish. 
There was an element of truth in this, of course: nothing was impossible. But in dealing with the future, we must think about two things: (a) what might happen and (b) the probability that it will happen.
During the crisis, lots of bad things seemed possible, but that didn’t mean they were going to happen. In times of crisis, people fail to make that distinction. . . . 
For forty years I’ve seen the manic- depressive pendulum of investor psychology swing crazily: between fear and greed— we all know the refrain— but also between optimism and pessimism, and between credulity and skepticism. In general, following the beliefs of the herd— and swinging with the pendulum— will give you average performance in the long run and can get you killed at the extremes. . . . 
If you believe the story everyone else believes, you’ll do what they do. Usually you’ll buy at high prices and sell at lows. You’ll fall for tales of the “silver bullet” capable of delivering high returns without risk. You’ll buy what’s been doing well and sell what’s been doing poorly. And you’ll suffer losses in crashes and miss out when things recover from bottoms. In other words, you’ll be a conformist, not a maverick; a follower, not a contrarian. 
Skepticism is what it takes to look behind a balance sheet, the latest miracle of financial engineering or the can’t-miss story. . . . Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t. The best investors I know exemplify this trait. It’s an absolute necessity. 
Lots of bad things happened to kick off the credit crisis that had been considered unlikely (if not impossible), and they happened at the same time, to investors who’d taken on significant leverage. So the easy explanation is that the people who were hurt in the credit crisis hadn’t been skeptical— or pessimistic— enough. 
But that triggered an epiphany: skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.