Howard Marks: 78 Years of Investing Wisdom in 60 Minutes (MUST WATCH)

How do you make money as an investor? The people who don't know think the way you do it is by buying good assets, a good building, stock in a good company, or something like that. That is not the secret for success. The secret for success in investing is buying things for less than they're worth.

As you know, I wrote a book in 2011 called "The Most Important Thing," and the reason it has that title is because I would find myself in my client's office, and I would say, "You know, the most important thing in investing is controlling risk." Then, five minutes later, I would say, "The most important thing is to buy at a low price," and five minutes later, I would say, "The most important thing is to act as a contrarian."

Back in 203, I believe I wrote a memo called "The Most Important Thing." I listed 19 things, each of which was the most important thing, and then I used that format for my book in 2011. Interestingly, some of the things are different, and that is supposed to show you that one's thinking should still be alive and evolve. I know that some of my colleagues went to see Charlie Munger speak in Los Angeles this week at age 91, and I’m sure he’s still evolving and getting younger, so I'm going to try to do the same.

Now, I should tell you, and I don't know if you know this, but I write memos to the clients, and I will refer to a lot of memos in this session, probably. They're all available on oakrycapital.com website, and the price is right—they're all free. You know, I've been sending them out now for 25 years. I started in 1990, and I got a letter from a guy named Warren Buffett in 2009 or 2010. He said, "If you'll write a book, I'll give you a quote for the jacket." So, I had been planning on writing a book when I retired from work, but Buffett's promise caused me to accelerate my time frame.

What the book is, is a recitation of my investment philosophy. As it says in the foreword to the philosophy, which I took very seriously—it says in there, "It’s not designed to tell you how to make money, and it's not designed to tell you how easy investment is, or to try to make it easy." In fact, my highest goal is probably to make it clear how hard it is. Investing is very difficult because it’s kind of counterintuitive, and it kind of turns back on itself all the time. There are no formulas that work.

What I tried to do in the book is teach people how to think. The thoughts they should hold change from time to time, but how to think, I think, is valid in the long term. It’s my investment philosophy, and I wasn't born with it. You'll hear from a lot of people if you're interested in investing who’ll say, "Well, I started reading prospectuses at age eight," or, "I invested my bar mitzvah money at thirteen," which I didn't do.

When I was getting out of graduate school at age 23 in 1969, I didn't know what I wanted to do. I had studied finance at Wharton and accounting at Chicago, and I knew I wanted to do something in finance, but I wasn't very specific. I interviewed in five or six different fields: large consulting firms, small consulting firms, accounting firms, corporate treasury, investment management, investment banking.

So, I ended up in the investment business. Why? Because I had a summer job in '68 at Citi in the investment research department. I liked it; I had fun. That’s a good reason! By the way, interestingly, there was nothing magical about working in the investment business at that time. It paid the same as all the rest. All six jobs that I was offered had the same pay, between $125,000 and $140,000 a year—not a month. There were no famous investors at that time; investing was not a household word. There were no investment TV shows, and so I just did it because I liked it. I liked the people, and I thought that investing was intellectually interesting.

I didn't have a philosophy when I started. I had some things that I had learned in school, but I think that your philosophy—as opposed to somebody, you know, if you study Descartes or Locke or somebody like that—you learn his philosophy. If you might learn a philosophy by studying a religion, but that's not your philosophy. Your philosophy will come from the combination of what you have been taught by your teachers and parents and your experiences, and what your experiences tell you about the things you were taught and how they have to be modified.

So I developed my philosophy over, you know, it might seem like I started writing the memos a long time ago—25 years—but I had been working already for over two decades at that time. The integration of real life into philosophy is essential.

Now, I prepared a few slides for today, and basically, the slides are here to illustrate where the philosophy came from and talk to you about some of the foundations and roots. So I call it "Origins and Inspirations," and I hope you'll find it interesting.

First of all, not in order chronologically, but hopefully in order to try to make something intelligible: "Fooled by Randomness" by Nassim Nicholas Taleb. Now, who here has read that? All right, more people than have read my book! I think it’s excellent, with very, very important ideas.

Now, don’t tell Nassim I said this, but I tell all the people I speak to that it is either the most important badly written book or the worst written very important book that you'll ever read. I think it’s not very clear. Maybe there's no attempt to make it clear, but I think a lot of the ideas are profound in my opinion. Among other things, the basic theme is that in investing, there’s a lot of randomness, and if you look at investing as a field without randomness, where everything is determinative, you’ll get confused because you will not draw the proper inferences from what you see.

For example, just a brief example: you see somebody, and they report a great return for the year. The scientist who thinks that the investment world runs like the world of physics might think, "Well, great return means he’s a great investor," but in truth, it might be somebody who took a crazy shot and got lucky. Why? Because there’s a lot of randomness in the world.

When I went to Wharton in 1963, the first book I remember learning was called "Decision Making Under Uncertainty" by C. Jackson Grayson, who became, as I recall, America’s first energy czar, and I learned a couple of important things from that book. Number one, that you can't tell from an outcome whether a decision was good or bad. It’s very important; most people don’t understand this. Totally counterintuitive!

But the truth is, in the real world where there's randomness at work, I mean, if you build a bridge and it falls down, then you must assume that the engineer made a mistake—that it was a bad decision to build the bridge that way. But in the real world, where every decision can have an outcome, good decisions fail to work all the time. Bad decisions work all the time. The investment business is full of people who are “quote right for the wrong reason.” They made a bad decision; it didn't work out the way they thought, but they got lucky.

So this is very important; this is the basic theme of "Fooled by Randomness." Taleb's first book. Since then, he has written “The Black Swan,” which became more famous, but I don’t think it’s as good a book. He’s written a book called “Antifragile,” and that one didn’t get famous, but I think that this book is something everybody should read if you have an interest in numbers, investing, and how the world works.

So, as I say, the book is all about the role played by luck, and basically, even if you know what’s most likely, many other things can happen instead. This is very, very important. We talked earlier at lunch about what’s the most important lesson you can draw. Well, of course, I can’t say the most important of anything, but one very important lesson for you to learn is that you should not act as if the things that should happen are the things that will happen.

Hey everyone, I just wanted to jump in here real quick and say that if you’re enjoying this video, you should download this completely free PDF at the link in the description because it contains 525 pages of Howard Marks’ legendary investment memos. I compiled these memos just for you as my thank you for supporting the channel. Thank you for all that you do, and now back to the video.

Again, in the world of the physical sciences, you can probably bet that that’s true, and the electrical engineer knows that if he turns on a light switch over here, the light will go on there every time because it’s subject to physics—not in the world of investing. For every possible phenomenon, there’s a range of things that can happen. There may be one where it's possible to discern which one is the most likely, and if we draw a probability distribution, that may be the highest point on the distribution, the most likely single outcome, but that doesn’t mean it’s going to happen.

The reason we don’t have many probability distributions that look like this, but rather that look like this, is because a range of things can happen. It’s very, very important to notice that number one: there are lots of things that can happen, so you have to allow for them; and number two: the thing that is most likely to happen is far from sure to happen.

So that’s very key. There’s a professor at the London Business School who put it succinctly; he said, “Risk means more things can happen than will happen.” This is profound in my opinion.

In the economic world, people generally make their decisions based on something called expected value, which is to say that you multiply every possible outcome. First of all, of course, you don’t think in terms of a single outcome; you think in terms of a range of outcomes. So, you take every possible outcome and multiply it by the likelihood that it will happen. You sum the results, and then you get something called the expected value from that course of action. You choose your course of action based on the highest expected value, and that sounds like a totally rational thing.

But what if the course of action that you’re considering has some outcomes that you absolutely can’t withstand? Then you may not do it. You may not do the highest expected value course of action because it has some outcomes you can't live with. You know who here is willing to be the skydiver who is right 98% of the time, for example?

So the point is, as I lived my life, talking and learning about Dimson, learning about Taleb, from learning from my own experience, I realized that “should” does not equal “will.” Lots of things that should happen fail to happen, and even if they don’t fail to happen, they fail to happen on schedule.

One of my favorite sayings is, “Never forget the six-foot tall man who drowned crossing the stream that was five feet deep on average.” We can't live by the averages. We can't say, "Well, I’m happy to survive on average." We got to survive on the bad days. You got to survive, and if you're a decision-maker, you have to survive long enough for the correctness of your decision to become evident, and you can't count on it happening right away.

I always remind people that overpriced is not the same as going down tomorrow, and if you bear that simple truth in mind, I think it helps. So, the role of luck is very important. Then there's John Kenneth Galbraith.

For those of you who are not familiar with ancient history, he was an American economist, died around ’05 I think, maybe a little after. At the age of about 98, he was one of my favorites. He was a little on the left side; he was somewhere between free enterprise and socialism, but he was what we call a liberal in the days when that word, when it was okay to say that word. He was very, very smart and he was not famous as an economist, but he played a lot of roles in government, and he was a diplomat.

He wrote some very good books, and one of them is called "A Short History of Financial Euphoria." I like thin books, so especially the ones he wrote in the last decade or two of his life were very thin. So, I enjoyed those, but the short history is very good, and I recommend that to you. One of the things he says is, “We have two classes of forecasters: the ones who don’t know and the ones who don’t know they don’t know.”

Now, I don’t believe in forecasts—macro forecasts. People who forecast interest rates, performance of economies, performance of stock markets, and I don’t think that my efforts to be a superior investor and most other people's are aided by macro forecasts.

So am I saying that the forecaster is never right? No, I’m not saying that. The forecasters are often right. Last year, GDP grew 2%. Many forecasters forecasted that GDP will grow this year at 2%. That’s called extrapolation, and usually in economics, extrapolation works. Usually, the future looks like the recent past, so usually the people who forecast a continuation of the current are right.

The only problem is they don’t make any money because let’s take the economy. Most people forecast two-something for this year. A growth rate of two-something is cooked into the prices of securities today. If the growth rate turns out to be two-something, everybody who forecasted that will be right, but the security prices will not change much because that two-something growth rate was anticipated and discounted a year or two ago.

So all those people who are right won’t make any money off their forecasts. That’s a correct observation. So most predictions, most extrapolations, work all the time. Forecasts that are extrapolations work all the time, but they don’t make any money. Logically, am I saying that forecasting never makes any money? No, the forecasts that make money are forecasts of radical change.

If I predict, if everybody's predicting 2.4% growth for this year and I predict minus two and it turns out to be minus two, or I predict six and it turns out to be six, I’ll make a lot of money. Forecasts that are not extrapolations, forecasts that are radically different from the recent past, are potentially very valuable if they’re correct. Of course, they’re not of any value if they’re incorrect. If they’re incorrect, they’ll cost you a lot of money.

If everybody else thinks it’s going to be 2.4 and you predict six, and it turns out to be 2.4, you're probably going to have taken the wrong investments and lost a lot of money. So deviant forecasts, which turn out to be right, are potentially very valuable, but it’s very hard to make them consistently.

Somebody at lunch mentioned an early memo I wrote called “The Value of Forecasts.” In that memo, I reviewed the recent history of the Wall Street Journal poll. Every six months, the Wall Street Journal publishes the results of a poll of economists on, you know, GDP growth, CPI, value of a dollar, price of oil, whatever it might be, a bunch of phenomena they do it consistently, and they ask around 30 people consistently over time.

So it shows basically that most of the time when people get it right, it’s because they predicted extrapolation and nothing changed. Once in a while, something changes radically, and invariably, somebody predicted it. But the problem is if you look at that person’s other forecasts over the years, you see that that person always made radical forecasts and never was right any other time.

So, of course, if you're getting your information from a forecaster, the fact that he was right once doesn't tell you anything. The views of that forecaster would not be of any value to you unless he was right consistently, and nobody's right consistently in making deviant forecasts.

So the bottom line for me is that forecasting is not valuable, and that is something that my experience has told me. We don’t know what’s going to happen, and randomness will play a big role in what happens, and randomness is by definition unpredictable.

Then, “The Loser’s Game” by Charlie Ellis. This is very interesting. Does anybody here know the name of the company TRW? A few people. TRW used to be a big conglomerate, and now it’s known primarily for credit scores. There was a guy named SAO; he was the “R” in TRW. Very smart. SAO wrote a book, and it was about winning at tennis.

Who here plays tennis? Okay, this is good, because as I go around the world now, very few people play tennis anymore. But what SAO said is that there are two kinds of winning tennis players: if you look at Pete Sampras or Nadal or Djoković, how do they win? The winning champion tennis player wins by hitting winning shots.

He hits shots that the opponent can't return; they’re either so well placed or so strategic or so fast and hard that the opponent can’t return. If Nadal hits a shot that isn't a potential winner, then his opponent can probably put it away because it doesn't have enough difficulty on the ball.

So the championship tennis player wins by hitting winners. You play tennis, right? How do you win? Do you win occasionally? How do you win? If I win, it’s by not hitting it out. That’s right! The amateur tennis player, like me, we win not by hitting winners, but by avoiding hitting losers.

We believe that if we can just push it back 20 times and just get it over the net 20 times, our opponent can only do it 19; we believe that we’ll outsteady him, outlast him, and eventually, he’ll hit it into the net or off the court. We'll win the point, but we’ll win the point without having hit a winner.

There are obviously two styles of tennis, and the same is true for investing. Charlie Ellis wrote an article called “The Loser’s Game,” and he said he thought that in investing, championship tennis is a winner’s game; it’s won by winners. He thought amateur tennis is a loser’s game, and it’s won by the people who avoid being losers.

Charlie thinks or thought that investing is a loser’s game, so the best way to win at tennis is by avoiding losers. Now, I believe it’s also a loser’s game—not as much as Charlie believes, and not for the same reason. Charlie believes that investing is a loser’s game because the market is efficient and securities are priced right.

I believe there are inefficiencies. I just think it’s hard to consistently take advantage of them, and you have to be an exceptional person to take advantage of them on a consistent basis. And you know the reason that the pro can go for winners is because he is so well-schooled and practiced and steady and talented that he knows that if he does this with his foot and this with his hip and this with his elbow and this with his wrist, that the ball will go where he wants. He doesn't worry about miscues, wind, sun in his eyes, distraction—he’s so well-schooled.

In scoring tennis matches, they keep track of something called unforced errors, and the reason they keep track of them is that there are so few. The pro doesn’t make a lot of unforced errors; we make unforced errors all the time. To survive, we have to avoid them. So the point is, if you're going to be an investor, you have to decide: am I good enough to go for winners, or should I emphasize the avoidance of losers in my approach?

The fourth input—I met Mike Milken in November 1978. So, in '78, I got a call from my boss at Citibank, and he said, "There’s some guy in California named Mike Milken, and he deals with something called high-yield bonds. Can you figure out what that means because one of our clients had asked for a high-yield bond portfolio?" At that time, nobody knew about it; it was unknown.

So I met with Mike in November of '78; he came to see me at Citi in New York. He was looking for clients; he was just starting off in the high-yield bond industry, and it was a great meeting. He explained to me that if you buy AAA bonds, there's only one way to go. AAA bonds are bonds that everybody thinks are great; their companies are making a lot of money, they have prudent balance sheets, and everything’s perfect.

If everything’s perfect, that means it can’t get better. If it can’t get better, that means it can only get worse. It doesn’t have to get worse, but if there is a change, it’s going to be for the worse, and if you’ve bought a bond on the assumption that it’s perfect, and it gets worse, then you lose money.

So, that’s important. On the other hand, he said, if you buy single-B bonds, and they survive, there’s only one way for them to go, which is upgrade. Now, that’s not exactly true because they can default and go bankrupt, but the ones that survive will go up, will be upgraded, and the surprises are likely to be on the upside.

This was very important; again, this is about trying to hit winners, avoid losers, and if you’re buying bonds that most people don’t think much of, it’s hard to have a big loser because such low expectations are incorporated.

Now, let me digress for a minute because this is really important: how do you make money as an investor? The people who don’t know think the way you do it is by buying good assets—a good building, stock in a good company, or something like that—that is not the secret for success. The secret for success in investing is buying things for less than they're worth.

If you buy a high-quality asset, you know, I say in the book there’s a guy on the radio—I used to, when I lived in LA, listen to NPR on the way to work—and there was a guy who said, "Well, if you go into a store and you like the product, buy the stock." Couldn’t be more wrong because what determines the success of an investor is not what he buys, but what he pays for it.

If you buy a high-quality asset but you overpay for it, you’re in big trouble. You can buy a very low-quality asset, but if you pay less than it’s worth, chances are you’re going to make money. So, the book says in Chapter 3, "The most important thing is value," figuring out what the value of an asset is. Chapter 4 says, "The most important thing is the relationship between price and value."

So, let’s assume that you’re able to figure out the value. If you pay more than that, you’re in trouble. If you get it for less, the wind is at your back. It was very important then to be in an area where surprises were likely to be on the upside.

If you buy the bonds of B-rated companies about which there are such low expectations, maybe it’s easy for there to be a favorable surprise. Now, how can I prove to you that the expectations were low? The answer is that if you look in the Moody's guide to bonds in those years, the definition of a B-rated bond was “fails to possess the characteristics of a desirable investment.” In other words, it’s a bad investment.

Now, I drove here from the airport in my car, and if I take you outside to look at my car and I offer it for sale because I don’t need that car anymore when I’m done here, if I say to you, “Would you like to buy my car?” what’s the one question you MUST ask me before saying yes or no? Price. You get an A!

So, in other words, it’s a good buy at a certain price; it’s a bad buy at another price. Moody's is saying that B-rated bonds are a bad buy without any reference to price. In other words, there’s no price at which a company that has some credit risk is worth investing in.

By the way, before I turned to high-yield bonds in '78, I was part of the bank’s machinery to buy the bonds of the stocks of America’s best companies. I explained at lunch how if you bought the bonds of H-Packet, Perkin Elmer, Texas Instruments, Merck, Lilly, Xerox, IBM, Kodak, Polaroid, AIG, Coca-Cola, and Procter & Gamble, and if you bought them all in '68 and you held them until '73, you lost 90% of your money.

Why? Because they were overpriced. The average stock since the postwar has traded at 16 times its next year’s earnings. These were trading at 80 and 90 times because they were so good; everybody thought, “Great companies; nothing can go wrong.” So, it didn’t matter what price you pay, and if you pay 80 or 90 times, that’s fine.

So here we are: In my experience again, as a teacher, you invest in the best companies in America, you lose a lot of money; then you go to the high-yield bond business, you invest in the worst companies in America, and you make the most money. It’s an instructive lesson if you have your eyes open and you learn from experience, which I did.

But the key words were “and they survive.” There’s a little trap there because you have to catch those three words. If you buy single-B bonds that don’t survive, then you’re in trouble. But it’s historically true that if a company about which the expectations are low survives, it’ll probably, at a minimum, pay off at maturity, and maybe in the meantime it’ll be upgraded or taken over if they survive.

What that convinced me when I was starting the high-yield bond business—and this conversation came at a great point in time—is that my analysts should spend all their time trying to weed out the ones that don't survive, not finding the ones that will have favorable events, but just excluding the ones that have unfavorable events, and that’s what we did.

So now, I’ll tell you an interesting story. Around '05 or '06, the Bible of investing is a book called "Security Analysis" written by Graham and Dodd. They wrote the first edition in 1934. Ben Graham was Warren Buffett’s teacher at Columbia and, in many ways, the father of value investing. He and David Dodd wrote this book in '34 and updated it in '40, and then several times after. The '40 edition is considered to be a great edition.

In '05, McGraw-Hill who owned the book said they wanted to update it. They turned it over to Seth Klarman, who’s a great dead investor in Boston, and a professor, I can't remember his name right now—H. Bruce Greenwald at Columbia. They turned it over to Seth and Bruce to bring out this revision, and they in turn asked people to revise the sections, and they asked me to revise the section on debt.

That meant I had to read the '1940 edition in order to update it, and I came across something fascinating, which verified what I had always thought: it said that bond investing is a negative art. What does that mean? It means I don’t know how many of you know how bonds work, but a bond is a promise to pay. You give me $100, and I promise to give you 5% interest every year and then pay back the bond in 20 years—fixed income.

It’s called that because all the events are fixed. The contract is fixed; the return is fixed. Assuming the promise is kept, all 5% bonds will pay 5%. None will pay six, none will pay four. All the ones that pay will pay 5%. What does that mean? It means of the ones that pay, it doesn’t matter which ones you buy. I’m going to like this one; I like that one a lot—that pays five. I like that one, that pays five—it doesn’t make any difference. You’re not going to be a hero by choosing among the bonds that pay.

The only thing that matters is to exclude the ones that don’t pay. If there are 100 bonds, 90 will pay—they’ll all pay the same thing. It doesn’t matter which of the 90 you choose; the only thing that matters is excluding the 10 that don’t pay. Negative art: the greatness of your performance comes not from what you buy, but from what you exclude.

I thought that was very useful; I should have that up here too, but anyway, so that Milken was my fourth input. So Taleb says that the future consists of a range of possibilities with the outcome significantly influenced by randomness, and Galbraith says that forecasting is futile, and Ellis says that if the game isn’t controllable, it’s better to work to avoid losers than to try for winners, and Milken says that holding survivors and avoiding defaults is the key in bond investing.

If you put them all together, that’s how you get the philosophy that’s in the book. These were my origins. When we started Oaktree, on April the 10th of 1995—almost exactly 20 years ago—we wrote down our investment philosophy, and here it is. We published it. We were a bunch of guys who had been working together for most of the previous 10 years at a different employer and we left there as a group and we started Oaktree.

I believe in writing things down, and like learning, as Taleb says today, write them down, right? So we wrote down our philosophy; we published it. We’ve never changed a word since, and the clients like knowing what our roadmap is.

These were the six tenets of the investment philosophy. The first one says that the most important thing is risk control, and we tell the clients we think that for excellence in investing, the most important thing is not making a lot of money, it's not beating the market, it's not being in the top quartile. The most important thing is controlling risk. That’s our job; that’s what we’ll do for you.

The clients come to us who want to invest in our asset classes with the risks under control. There are other people who put less emphasis on controlling risk, and they have better results in the good times and worse results in the bad times. Our clients want what we give them.

Number two, we have an emphasis on consistency. We say we don’t try for the moon at the danger of crashing. You know, the first memo that I wrote in 1990—I’m sure you remembered that I talked about a guy who was the head of an asset manager that had a terrible year, and he said, "Well, it's very simple. If you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%."

I have no interest in being in the bottom 5%. I don’t care about being in the top 5%. I want to be above the middle on a consistent basis over the long term. There’s a funny bit of math; this will confound the data scientists in the room, but in that first memo, I contrasted the comments from that money manager with a comment from one of my clients who told me right about the same time—this was the juxtapositions that caused me to write that first memo.

He said that for the previous 14 years, his pension fund had never been above the 27th percentile or below the 47th percentile, so it was solidly in the second quartile every year for 14 years. So let’s see, 27-47, the average of that is 37, right? What percentile do you think that fund was in for the whole 14 years? Four!

If you think about it, it’s really almost mysterious: why was it the fourth and not the 37th? The answer is that when people blow up, they really blow up. So we said we want consistency; we want to be a little bit above the middle all the time. Maybe we’ll pop up to the top in the years when the markets are terrible and our risk-control is rewarded, but we think that over a long period of time, we’ll be very respectable that way and our clients will have an absence of bad experiences, which I think for them is very important.

Then macro forecasting is not critical to investing; we do not make our decisions based on macro forecasts, as I explained to you. We all have opinions; our official dictum is that it’s okay to have an opinion, you just shouldn’t act as if it’s right. I think this is very important.

You know, Mark Twain said, “It's not what you don’t know that gets you into trouble; it's what you know for certain that just ain’t true.” So we try to avoid holding strongly to those macro opinions, and finally, we don’t do a lot of market timing, which is very, very hard to do. We do long-term investing in assets that we think are underpriced.

So that’s the Oaktree philosophy. You can see how the origins and inspirations I went through fed into that, and in fact, it’s all distilled in our motto, which says that if we avoid the losers, the winners will take care of themselves. If we can make a large number of investments and just weed out the problems, then we’ll have, just think of the bell-shaped curve, we’ll have a lot that do okay and an occasional one which is exceptional if we can weed these out.

So a lot of money managers go into the clients and say, "We will get you in the top quartile, into the great right-hand tail." I think it’s hard to do on a consistent basis, and if you aim for the right-hand tail and you miss, you end up in the left-hand tail. What we say is we’ll just lop off the left-hand tail, and if we can do that successfully, and we pretty much have, then what will you have? Okay, good, very good, great, terrific, but no terrible. The average will be very good, and that’s basically what we’ve had.

So lastly, I’ll just leave you with what I consider my three greatest adages—not mine, but the ones I've encountered over my career that have been the most helpful, and they’re all used in the book. First of all, “What the wise man does in the beginning, the fool does in the end.” In every trend in investing, it eventually becomes overdone. If you find an asset that’s cheap and you buy it, that’s great. If everybody else figures out that it’s cheap, then it’ll go up.

Then people see that it’s rising, and more people jump on the bandwagon, and it goes up, up, up. The last person to buy it is a fool and the first person to buy it is a wise man. It’s the same asset, just at different prices. And as people say, first, the innovator, then the imitator, then the idiot. So that’s another way to look at this adage.

Number two: “Never forget the six-foot tall man who drowned crossing the stream that was five feet deep on average.” Kind of like that skydiver who’s right 98% of the time; it's not sufficient, depending on how you want to live your life, to survive on average. We have to survive on the bad days, so we have to be able to survive the low spots in the stream. Your portfolio has to be set up to survive on the bad days, so you won’t be shaken out of your investments.

Finally, “Being too far ahead of your time is indistinguishable from being wrong,” and yet that's a great challenge because, as I said before, the things that are supposed to happen will not necessarily happen—and they absolutely will not happen on time. So you have to be able to live until the wisdom of your decisions is proved, if at all.

All of these things, I think, say something about modesty and humility of belief rather than chest which I think is the greatest risk. So with that, I'll stop talking, and we have a little time left; I’d love to take your questions. That's what I’m here for!

Thank you, Howard; this was fascinating. So we are open for questions. Please raise your hand, and I’ll bring the mic to you.

The thing you said about what the wise man does in the beginning, the fool does in the end—can come up from a single stock, and you can think about your whole philosophy that way. So you’ve been focusing here on avoiding losers, and maybe humans are kind of generally focused on trying to find winners. Maybe that’s why we’ll always do wrong. But if everybody in the world was trying to avoid losers, maybe the wise investor now shoots for the winners.

Do you know what I mean? It’s sort of self-balancing.

Sure. Well, number one, I don’t think we have to worry about everybody becoming too prudent or too wise because we’re talking about human nature. Charlie Munger— the boys went to see Charlie Munger this week. One of the great quotes that Charlie gave me was from the philosopher Dinesh, who said, “For that which a man wishes, he will believe.” What do most people want more than anything else? They want to get rich! Very few people think that the future—that the secret to their happiness comes from prudence and caution.

Most people think it comes from that stroke of genius which will put them on Easy Street. So, but you’re absolutely right, and there are times when most people behave in a prudent and cautious manner. When is it? It’s in a crash, when security prices are down here, right? That’s the time to turn aggressive and buy.

So Buffett says, "The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs." There are times when we should turn aggressive, and that’s when everything's being given away.

So you said that you do not predict and you do not make any macro forecasts, right? But actually, the macros can affect companies in a lot of ways. I mean, if you have interest rates like 30%, 99% of the companies will be gone or something like that, right? So how do you even make an investment?

Okay, so now I know I’m not coming back to Google anymore because the people are too intelligent, because this is one of the great traps. I say that we don’t invest on the basis of macro forecasts, but you have to have an economic framework in mind when you predict the fortunes of individual companies.

What I would say is we try to do is, you know, it’s one thing to say that oil is at 50, and we’re going to invest in this company because it will do fine if oil’s at 50, survive if it goes to 30, and thrive if it goes to 70. But it’s another thing to say oil is 50, I think it’s going to 110, I’m going to invest in this company which is going to be great if it goes to 110 but bankrupt if it stays at 50.

So the question is how radical are your forecasts? We try to anticipate a future that looks pretty much like the norm and make allowance for the things that, that things other than the norm can happen. I can’t really be much more concrete than that. It’s all, you know, by the way, all this stuff is judgment. There are no rules; there are no algorithms; there are no formulas that always work. None of this is any good unless the person making the decision has superior judgment.

The first chapter of the book says the most important thing is second-level thinking. Most people think on the first level. To be a superior investor, you must think on the second level. You have to think different from everybody else. But in being different, you have to be better.

The first-level thinker is naïve; he says, "This is a great company, let’s buy the stock." The second-level thinker says, "It’s a great company, but it’s not as great as everybody thinks it is; we better sell the stock." That’s the difference between being an average person and a person with superior insight.

By the way, most people are not above average.

Yes, sir. Do you think diversified index funds adequately protect the amateur investor from losers?

Well, this is a great question—the role of the index fund. A lot of people say, “I’m going to take a low-risk approach; I’m going to invest in an index fund,” and they are confused. What an index fund does is it guarantees you performance in line with the index.

The point is, because of the operation of what’s called the efficient market, not many people can beat the market. It’s true; most mutual funds do not beat the market. Most mutual fund investors would be better off just to be in an index fund. In fact, most active investment schemes impose fees that they don’t earn, and that is one of the major reasons that most active investment schemes perform below average.

So the index fund, which is called passive investing, yes, it does reduce the likelihood that you fail to keep up with the index. It also, of course, eliminates the possibility that you outperform the index. So you trade away the two sides of the probability distribution for safety, but it doesn’t eliminate the risk of the investment; it eliminates the risk of deviating from the index.

What you have to keep in mind is that the index fund investor loses money every time the index goes down. Why? Because there’s no value added to keep it above. So by the way, index investing is a fine thing for the average amateur investor because the average amateur investor, number one, can’t beat the market; number two, can’t find anybody or hire anybody who can beat the market.

But the only thing is he shouldn’t think that it’s a riskless trade. You eliminate what we call benchmark risk, but you retain the risk of the underlying assets.

Sorry, you’ve been through one or two of these business cycles, I guess. With the availability of information and with the number of books being written about this subject, about value and proper investing and how many managers don’t beat the market, do you think the average investor is doing anything different than they were 20 years ago?

Well look, I think there’s a minor movement toward indexation. It’s not a groundswell; there’s still lots of money in actively managed mutual funds, where there’s 2% a year of fees and costs, or one and a half. But I think there’s more in indexation every year, and that’s probably appropriate.

But here’s an I’ll just turn it around; I’ll leave you with a question. Why can’t people beat the market? Because the market’s pretty efficient, and market prices most things right, and most people can’t find and identify and act on the times when the market prices things wrong.

That’s why most people can’t beat the market. That’s what I learned at the University of Chicago, and I think it’s pretty true. So the reason for the inability to beat the market is the market’s efficiency. The market’s efficiency comes from the concerted efforts of thousands of investors who are trying to find the bargains.

What happens when they stop trying? So when the interest in active investment declines because people give up on it and turn to passive investing, and all the analysts quit studying the companies, then prices resume their deviation from intrinsic value. Then it becomes possible to beat the market again.

So it’s really paradoxical, and I would say counterintuitive, but I don’t think we’re close to that day. In theory, there comes a day when so little attention is being paid to active investing that active investing starts working again.

Yes, sir.

Thanks, Howard, for coming for the talk. One question: Buffett, in '99, said that if he was running very small amounts of money, he would be able to find lots of bargains and beat the market by 50%, and he would use the word guaranteed. I presume he meant that there are a lot of inefficiencies in the small capitalization stocks.

One thing that kind of surprises me is: if someone—an analyst willing to work hard on his own—not in an institution, the world of distress debt investing is kind of shut out even for the value investor, filled with a lot of technicalities, and it seems like the big institutions have a lot of advantages there. Are there such inefficiencies that are kind of shut out to the institutions, but the small investor willing to work hard can find inefficiencies in the debt world?

Well, I think that the small guy can even be active in distress debt. He can’t get enough bonds to get a seat at the creditors committee table or have a voice, but he can still find superior values. You know, so what I was saying in answer to your question is that if you have good—if you get some accounts and you have good performance, you’ll get more accounts.

What I really say is that if you have good performance, you’ll get more money. And eventually, if you let that process become unchecked, if you get more money, you’ll have bad performance, and this is one of the conundrums in our business. So you have to hold that.

The truth of the matter is that the little guy has an advantage as long as he’s willing to stay small. Many people are not, because in the short run, the more money you manage, when you get fees, there’s a great lure to take on more money.

But you have to stop it at a point before it starts ruining your performance. Now, for the data scientists among us, I always like to point out that if I worked at, you know, Firestone Tires and I developed a new tire and I wanted to know how far it would go, I would put it on a car and run it until it blew up, right? That’s called destructive testing.

But as an investor with clients and fiduciary responsibility, I don’t have the luxury of doing destructive testing. So I can’t add more people. People always say to me, “Well, what’s the limit on how much money you can invest?” Well, I can’t find out by running into the wall! I have to stop this side of the wall.

One of the interesting lessons is that if you stop this side of the wall, then you never find out where the wall really is, but that’s what we have to do. So you have to stop, and I believe that the person who has a big brain and little money and a lot of time and exceptional insight can find great bargains.

But you know, that's a pretty daunting list, and I don’t think that Buffett’s guarantee necessarily extends to everybody in this room.

Do you see any unhealthy trends in valuation in the market today, the same way tech or housing was valued in the past?

Yes, I do, because the market extends—the menu extends—the what we call the Capital Market line extends from what’s called the risk-free rate. The risk-free rate is the rate, generally speaking, on the 30-day Treasury bill. Of course, if you can get 3% on the risk-free rate, then in order to tie up your money for five years in a 5-year Treasury, you want four, and to get it years, you want five.

If you can go into a corporate security that has some credit risk, you would demand six, and to go into a high-yield bond, you would demand 12, and so forth. There’s a kind of a process called equilibration, which makes things line up in terms of relative risk and return, but always tied and pegged from the risk-free rate.

Today, the risk-free rate is zero, so everything that I just named—the Capital Market line—has had a parallel downward shift. Before the crisis, I had, you know, Sirab mentioned that I turned bearish. All my money was in Treasuries— all the money that I had outside of Oaktree was in Treasuries, and I was getting six and a half percent for one, two, three, four, five, six-year maturities. I was getting income and safety.

Today, you have a choice: income or safety? Because the things today that are highly safe pay no income. If you go to Fidelity and conduct an experiment, go to Fidelity or Vanguard or a big mutual fund firm, and go online and look at their menu of offerings, what is the current yield on current net yield after fees and expenses?

You’ll see that for money market and short-term Treasuries and maybe intermediate Treasuries, the yield is zero. Just think: the guy watching the Super Bowl in his undershirt gets a statement from Fidelity. He opens it up, and it says, “The yield on your fund is now zero.”

He grabs the phone, calls the 800 number, says, “Get me out of that fund that yields zero and put me in the one that yields six.” He becomes a high-yield bond investor. He has no idea why; he doesn’t know what a high-yield bond is; he doesn’t understand what the dangers are; he doesn’t understand how to pick a high-yield bond manager. But he’s seduced by that 6% versus zero.

All around the investment world today, people are chasing return. They don’t like the low returns that are available on safe instruments; they’re going for the gusto. They’re going for riskier instruments, and they’re doing it mindlessly.

I promise you I’d mentioned some memos; I forgot to do that. But if you go back, I wrote one in March of ’07 called “The Race to the Bottom,” and I talked about the fact that when people are, number one, eager to invest, and number two, not sufficiently risk-conscious, they do risky things. When people do risky things, the market becomes a risky place, and that’s why Buffett says, “The less prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own affairs.”

That is going on now to some extent because people can’t get a good return from safe instruments; they’re going into the risky ones and they’re bidding. You know, there’s a bond that’s going to be issued by a company. I say, “I demand 7% interest,” and this fellow says, “No, I’ll take six.” That guy says, “I’ll take five.” I say, “I want protective covenant to make sure that the company can’t do things that ruin its own creditworthiness.” He says, “I’ll do it with less covenants.” That guy says, “I’ll do it with no covenants.”

What happens? The bond is issued at 5% with no covenants. That’s the race to the bottom. Anyone who participates in that bond probably, you know, could be making a mistake.

That’s going on now—not to the same terrible extent that it was in '06 and '07—but you’ve got to be careful today. Oaktree’s motto for the last three and a half years has been “Move forward but with caution.” Caution has to be a very important component of everybody’s actions today.

Well, thank you very much for being with me, and I hope you enjoyed it. When I think of more stuff, I’ll come back. Thank you so much.