While Jesse Livermore was a legendary trader who made riches and went bankrupt many times by cornering markets during 1900-1930 (when it was legally allowed), Benjamin Graham was a value investor and wrote a seminal book Security Analysis – often remarked as the bible of value investing. Howard Marks, on the other hand, made his name investing in high yield junk bonds in the 80s onwards.
What links all of them is not just their successes in the market but also the fact that they realised something important – if one avoids the losers, the winners will take care of themselves.
Marks, writing in his memo to clients earlier this week, said the best foundation for above-average long-term performance is an absence of disasters. That is, it is not about choosing winners every time you invest, but to avoid losers.
“If we invest in a diversified portfolio of bonds and are able to avoid the ones that default, some of the non-defaulters we buy will benefit from positive events, such as upgrades and takeovers. That is, the winners will materialize without our having explicitly sought them out,” said Marks.
For long, Marks, while recounting a couple of anecdotes says, he prided himself to be the first to have this enlightenment. Though, this shattered when he realised that Graham and Livermore had worked on this philosophy way earlier than him.
Graham in his above mentioned book talks about “fixed-value” (or fixed-income) investing as “a negative art”, which Marks came across when editing Security Analysis in 2005. Though the observation seems cynical, Marks suggests, the meaning was profound and something he was familiar with.
“Let’s assume there are one hundred 8% bonds outstanding. Let’s further assume that ninety will pay interest and principal as promised and ten will default. Since they’re all 8% bonds, all the ones that pay will deliver the same 8% return – it doesn’t matter which ones you bought. The only thing that matters is whether you bought any of the ten that defaulted. In other words, bond investors improve their performance not through what they buy, but through what they exclude – not by finding winners, but by avoiding losers. There it is: a negative art,” Marks explains, citing an example.
Similarly, a few years ago Marks came across a book written by Livermore while scavenging for old books in a book fair – How to Trade in Stocks. Apparently, the book had a quote: “Winners take care of themselves; losers never do.”
Avoiding losers in equities
Though not explicitly mentioned, the same theory can be applied in equities as well. Some of the most renowned money managers and investors have used this philosophy to become successful.
Marks cite the example of Warren Buffett, calling him “arguably the investor with the best long-term record and certainly the longest long-term record”. He is is widely described as having had only twelve great winners in his career.
“His partner Charlie Munger told me the vast majority of his own wealth came not from twelve winners, but only four,” Marks writes. “I believe the ingredients of Warren’s and Charlie’s great performance are simple: (a) a lot of investments in which they did decently, (b) a relatively small number of big winners that they invested in heavily and held for decades, and (c) relatively few big losers. No one should expect to have – or expect their money managers to have – all big winners and no losers.”
Marks underline that when he says avoid losers, he does not say one should not take risks at all, as that will be counterintuitive. Because, unless one takes a risk, one cannot reap the rewards that come with that.
“There’s such a thing as the risk of taking too little risk. Most people understand this intellectually, but human nature makes it hard for many to accept the idea that the willingness to live with some losses is an essential ingredient in investment success,” Marks adds.
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