- First-level thinking: “It’s a good company; let’s buy the stock.”
- Second-level thinking: “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.”
- First-level thinking: “The outlook calls for growth and rising inflation. Let’s dump our stocks.”
- Second level thinking: “The outlook stinks, but everyone else is selling in panic. Buy!”
Once one is able to think on a higher level, he/she must understand the limitations of market efficiency. A product of the “Chicago School” of investing, Marks found himself at ground zero of the efficient market hypothesis while learning at the University of Chicago’s Graduate School of Business. The efficient market hypothesis essentially states the following:
- There are a lot of intelligent, objective and highly motivated participants in the markets, all with roughly equal access to the same information.
- Information will be reflected fully and immediately in market price.
- Because market prices represent accurate estimates of intrinsic value, no participant can consistently identify and profit from when markets are wrong.
- Assets sell at prices from which they can be expected to deliver risk-adjusted returns that are fair relative to each other – riskier assets offer higher returns to attract buyers. (There are periods where riskier investments deliver higher returns. Yet, as Marks points out, if riskier investments could always be counted on to give higher returns, they would not be riskier.)
However, as Marks points out, just because a market is efficient, it does not mean that it’s right. Efficient simply means that the markets reflect the current consensus. Marks’ example is of Yahoo stock, priced at $237 in January 2000 and $11 in April 2001. He says that anyone who claims the market was right at both times has his/her head in the clouds. The existence of wrong market prices (meaning well above or well below intrinsic values) is an indicator of market inefficiency. Another indicator of inefficiency is that some investors can consistently outperform others. These investors can identify misvalulations with their skill, insight and information access. Inefficiencies provide mispricings for investors to profit from on the basis of individual skill.
In a 100% efficient market, everyone should just give up on beating the market because the consensus would always be completely reflected, paving the way for average results. Marks says that efficiency is a “rebuttable presumption” – something that should be assumed to be true until proven otherwise. The bottom line is that “inefficiency is a necessary condition for superior investing”, but this alone will not get you a better return. The individual investor must be more insightful than others to use the mispricings to his/her advantage.
“Let others believe markets can never be beat. Abstention on the part of those who won’t venture in creates opportunities for those who will.” – Howard Marks, chairman of Oaktree Capital Management