Different and Better

On thinking, investing, and living

I was fortunate to take a class taught by the late Jack McDonald, professor at the Stanford GSB, while at law school. Jack was an impressive figure who, over the course of five decades, taught and mentored some of the most successful investors of all time. The class was ostensibly about the tactics and strategy of financial investments, but Jack made clear from day one that his philosophy — that the best things in life come from disciplined investment over the long term — applied to personal investments as well. The extraordinary community around Jack served as a testament to the successful investments he had made in relationships over many years.

His professional record was equally impressive. As a famed value investor, he was a contrarian within the faculty ranks of the GSB, where academic work was dominated by efficient markets theory. Jack’s personal warmth was a critical enabler of his intellectual iconoclasm because, as I recall him saying, friends and colleagues can more effectively and constructively disagree within a framework of mutual respect and regard. It didn’t hurt that his investment record and that of his intellectual ally Warren Buffett remain a curious exception to the efficient markets conclusion that consistent outperformance by active financial managers over long periods is impossible.

I was reminded of Jack’s philosophy recently while reading The Most Important Thing by Howard Marks, the co-founder and co-chairman of Oaktree Capital Management. Marks is an exceptionally clear and lucid writer (and thinker) and the book, which is built around excerpts from his regular memos to clients, begins with the seemingly obvious but under-appreciated observation that investors cannot achieve unconventional results with conventional thinking and behaviour. First level thinking — collecting, analysing, and reasoning about the same set of facts as most others and reaching similar conclusions — guarantees results consistent with or worse than consensus. To outperform, one must think different and better and act accordingly; this is second level thinking and it requires collecting a broader set of information, integrating it successfully, remaining humble about what is unknown and unknowable, and recognising that most people only engage in first level thinking. This final point is perhaps the most critical and has been brilliantly explained in similar terms by George Soros in his essay on reflexivity. In human affairs, Soros argues, we must recognise that the psychology and self awareness of the people involved is a critical, complex, and shifting element of outcomes. The mere knowledge that something is the case or that some relationship holds is often sufficient to change behaviour so that it is no longer the case. This is the source for Soros of the deep and abiding divided between the physical and social sciences. Both are vital, but we are likely to err when we mistake human bodies for Newtonian bodies. Reflexive human interactions resist being modelled in the same way that physical scientists model laws of nature.

In the context of investing, thinking different and better means being contrarian — and right. But how? Everyone claims to be contrarian in at least some regard, which is, of course, how we know it is not true. Most people are the herd as we can see by observing the latest social fad or investment behaviours, and everyone is part of the herd in at least some regard. The trick is to be contrarian and right in domains of importance where the returns to doing so are high. Marks argues that, in a professional context, this requires bringing to bear a set of intellectual tools that enable consistently superior thinking applied in a disciplined manner. His recommendations can be grouped into two categories:

• Analytical Heft to enable identification of some fact, quality, or characteristic of reality that others don’t yet recognise and are therefore failing to integrate into their thinking. You must also be correct in this identification.
• Psychological Fortitude to act on that analysis and withstand the loneliness and, perhaps, ridicule likely to result until the consensus view shifts in your favour.

The Most Important Thing was written in 2011 and discuss how Oaktree was able to understand, recognise, and manage risk during the bull market before the financial crisis of 2008 in a way that limited losses and drove massive outperformance during the recovery. While he is very clear that he did not predict the crisis, he did successfully identify and articulate the risk building in the system in the years before and acted aggressively to defend against it. (Aggressive defence captures a lot of his recommendations.)

Reading his recommendations in 2021 is interesting because, while value has been handsomely outpaced by growth since the financial crisis, the unacknowledged risks being taken in 2004–2007 that Marks analysed bear many similarities to some current market behaviour. Now, like then, the sense in financial markets is that risk is low and “stonks only go up”. Asset prices, buoyed by extremely loose monetary policy, are at or near all time highs and the recent acceleration of prices is reminiscent of jubilant periods that preceded falls. Not satisfied with seeing their neighbour or fellow Redditor get rich, retail is crowding in to equities in record numbers, afraid of missing out on the seemingly low risk rise of the hottest stocks. Novel financial products with questionable economics are proliferating (SPACs) and crazy financial behaviour is dominating headlines ($GME). Marks’s recommendations prompt a clear conclusion: hold onto your wallet. With prices very high, the perception is that risk is low and expected return high; the reality is that, because markets are cyclical, risk (understood more broadly than the theoretical identification of risk with volatility) is high and expected returns are low. Bull markets eventually end.

Note, though, that Marks was sounding the alarm in 2004 about a crisis that manifested in 2008. So, while he was analytically correct, it required enormous psychological fortitude to look wrong for a long time. This is the rub. It is easy to articulate a set of principles for thinking and acting but it takes conviction and discipline to actually apply those principles when the herd is heading in the other direction. Jack embodied this discipline by applying the principles of long term perspective, analytical clarity, humility, integrity ,and conviction to cultivate success in investing but also in life. He taught me that the most rewarding returns of any kind are the result of sustained, disciplined, and high integrity investment over very long periods. What could be a more important thing than that?