Since that original memo, I’ve made a few adjustments in the things I consider “the most important,” but the fundamental notion is unchanged: they’re all important. Successful investing requires thoughtful attention to many separate aspects, all at the same time.

“Experience is what you got when you didn’t get what you wanted.” Good times teach only bad lessons: that investing is easy, that you know its secrets, and that you needn’t worry about risk. The most valuable lessons are learned in tough times.

Most professional investors had joined the industry in the eighties or nineties and didn’t know a market decline could exceed 5 percent, the greatest drop seen between 1982 and 1999.

The Most Important Thing Is Second-Level Thinking

First-level thinking says, “It’s a good company; let’s buy the stock.” Second-level thinking says, “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 says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”

First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.”

The second-level thinker takes a great many things into account:

• What is the range of likely future outcomes?
• Which outcome do I think will occur?
• What’s the probability I’m right?
• What does the consensus think?
• How does my expectation differ from the consensus?
• How does the current price for the asset comport with the consensus view of the future, and with mine?
• Is the consensus psychology that’s incorporated in the price too bullish or bearish?
• What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
  

All investors can’t beat the market since, collectively, they are the market.

extraordinary performance comes only from correct non-consensus forecasts, but non-consensus forecasts are hard to make, hard to make correctly and hard to act on.

The upshot is simple: to achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That’s not easy.

The Most Important Thing Is Understanding Market Efficiency (and Its Limitations)

The efficient market hypothesis states that:

• There are many participants in the markets, and they share roughly equal access to all relevant information. They are intelligent, objective, highly motivated and hardworking. Their analytical models are widely known and employed.
• Because of the collective efforts of these participants, information is reflected fully and immediately in the market price of each asset. And because market participants will move instantly to buy any asset that’s too cheap or sell one that’s too dear, assets are priced fairly in the absolute and relative to each other.
• Thus, market prices represent accurate estimates of assets’ intrinsic value, and no participant can consistently identify and profit from instances when they are wrong.
• Assets therefore sell at prices from which they can be expected to deliver risk-adjusted returns that are “fair” relative to other assets. Riskier assets must offer higher returns in order to attract buyers. The market will set prices so that appears to be the case, but it won’t provide a “free lunch.” That is, there will be no incremental return that is not related to (and compensatory for) incremental risk.
  

although the more efficient markets often misvalue assets, it’s not easy for any one person—working with the same information as everyone else and subject to the same psychological influences—to consistently hold views that are different from the consensus and closer to being correct.

Because theory says in an efficient market there’s no such thing as investing skill (commonly referred to today as alpha) that would enable someone to beat the market, all the difference in return between one investment and another—or between one person’s portfolio and another’s—is attributable to differences in risk.

if you show an adherent of the efficient market hypothesis an investment record that appears to be superior, as I have, the answer is likely to be, “The higher return is explained by hidden risk.” (The fallback position is to say, “You don’t have enough years of data.”)

Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both. They are on the alert for instances of misperception. My son Andrew is a budding investor, and he comes up with lots of appealing investment ideas based on today’s facts and the outlook for tomorrow. But he’s been well trained. His first test is always the same: “And who doesn’t know that?”

Because assets are often valued at other-than-fair prices, an asset class can deliver a risk-adjusted return that is significantly too high (a free lunch) or too low relative to other asset classes.

For every person who gets a good buy in an inefficient market, someone else sells too cheap. One of the great sayings about poker is that “in every game there’s a fish. If you’ve played for 45 minutes and haven’t figured out who the fish is, then it’s you.” The same is certainly true of inefficient market investing.

Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return?

Do you really know more about the asset than the seller does?

If it’s such a great proposition, why hasn’t someone else snapped it up?

Many of the best bargains at any point in time are found among the things other investors can’t or won’t do.

The key turning point in my investment management career came when I concluded that because the notion of market efficiency has relevance, I should limit my efforts to relatively inefficient markets where hard work and skill would pay off best.

The Most Important Thing Is Value

For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.

buy at a price below intrinsic value, and sell at a higher price. Of course, to do that, you’d better have a good idea what intrinsic value is. For me, an accurate estimate of value is the indispensable starting point.

The random walk hypothesis says a stock’s past price movements are of absolutely no help in predicting future movements.

as I see it, investors who practice this approach operate under the assumption that they can tell when something that has been rising will continue to rise.

we are left with two approaches, both driven by fundamentals: value investing and growth investing.

value investors aim to come up with a security’s current intrinsic value and buy when the price is lower, and growth investors try to find securities whose value will increase rapidly in the future.

Value investors typically look at financial metrics such as earnings, cash flow, dividends, hard assets and enterprise value and emphasize buying cheap on these bases. The primary goal of value investors, then, is to quantify the company’s current value and buy its securities when they can do so cheaply.

Value investors buy stocks (even those whose intrinsic value may show little growth in the future) out of conviction that the current value is high relative to the current price.

Growth investors buy stocks (even those whose current value is low relative to their current price) because they believe the value will grow fast enough in the future to produce substantial appreciation.

Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.

“Being too far ahead of your time is indistinguishable from being wrong.”

If you liked it at 60, you should like it more at 50 . . . and much more at 40 and 30.

Value investors score their biggest gains when they buy an underpriced asset, average down unfailingly and have their analysis proved out. Thus, there are two essential ingredients for profit in a declining market: you have to have a view on intrinsic value, and you have to hold that view strongly enough to be able to hang in and buy even as price declines suggest that you’re wrong. Oh yes, there’s a third: you have to be right.

The Most Important Thing Is The Relationship Between Price and Value

Investment success doesn’t come from “buying good things,” but rather from “buying things well.”

no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough.

“Well bought is half sold.” By this we mean we don’t spend a lot of time thinking about what price we’re going to be able to sell a holding for, or when, or to whom, or through what mechanism. If you’ve bought it cheap, eventually those questions will answer themselves. If your estimate of intrinsic value is correct, over time an asset’s price should converge with its value.

Since buying from a forced seller is the best thing in our world, being a forced seller is the worst. That means it’s essential to arrange your affairs so you’ll be able to hold on—and not sell—at the worst of times. This requires both long-term capital and strong psychological resources.

In the tech bubble, buyers didn’t worry about whether a stock was priced too high because they were sure someone else would be willing to pay them more for it.

I believe that an investment approach based on solid value is the most dependable. In contrast, counting on others to give you a profit regardless of value—relying on a bubble—is probably the least.

Buying something for less than its value. In my opinion, this is what it’s all about—the most dependable way to make money.

The Most Important Thing Is Understanding Risk

"Risk means more things can happen than will happen." Elroy Dimson

Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.

when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks.

riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple: if riskier investments reliably produced higher returns, they wouldn’t be riskier!

risk of loss does not necessarily stem from weak fundamentals. A fundamentally weak asset—a less-than-stellar company’s stock, a speculative-grade bond or a building in the wrong part of town—can make for a very successful investment if bought at a low-enough price.

Ben Graham and David Dodd put it this way more than sixty years ago in the second edition of Security Analysis, the bible of value investors: “the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation.”

Did the investor do a good job of assessing the risk entailed? That’s another good question that’s hard to answer. Need a model? Think of the weatherman. He says there’s a 70 percent chance of rain tomorrow. It rains; was he right or wrong? Or it doesn’t rain; was he right or wrong? It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.

“There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” That’s one of the most important things you can know about investment risk.

Now that investing has become so reliant on higher math, we have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world. Quantification often lends excessive authority to statements that should be taken with a grain of salt. That creates significant potential for trouble.

We hear a lot about “worst-case” projections, but they often turn out not to be negative enough. I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away.

The Most Important Thing Is Recognizing Risk

"My belief is that because the system is now more stable, we’ll make it less stable through more leverage, more risk taking.” - Myron Scholes

Whereas the theorist thinks return and risk are two separate things, albeit correlated, the value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices. Thus, awareness of the relationship between price and value—whether for a single security or an entire market—is an essential component of dealing successfully with risk.

investors shouldn’t plan on getting added return without bearing incremental risk. And for doing so, they should demand risk premiums.

When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so . . . and risk compensation will disappear.

developments that make the world look less risky usually are illusory, and thus in presenting a rosy picture they tend to make the world more risky.

Risk cannot be eliminated; it just gets transferred and spread.

Everything you needed to know in the years leading up to the crash could be discerned through awareness of what was going on in the present.

when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.

The Most Important Thing Is Controlling Risk

great investors are those who take risks that are less than commensurate with the returns they earn. They may produce moderate returns with low risk, or high returns with moderate risk. But achieving high returns with high risk means very little—unless you can do it for many years, in which case that perceived “high risk ” either wasn’t really high or was exceptionally well managed.

loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.

risk control is invisible in good times but still essential, since good times can so easily turn into bad times.

Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.

Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.

The Most Important Thing Being Attentive to Cycles

I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.

Rule number one: most things will prove to be cyclical.

Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

The basic reason for the cyclicality in our world is the involvement of humans. Mechanical things can go in a straight line.

Look around the next time there’s a crisis; you’ll probably find a lender. Overpermissive providers of capital frequently aid and abet financial bubbles.

The Most Important Thing Is Awareness of the Pendulum

Investment markets follow a pendulum-like swing:

• between euphoria and depression,
• between celebrating positive developments and obsessing over negatives, and thus
• between overpriced and underpriced.
  

In fact, I’ve recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both.

Very early in my career, a veteran investor told me about the three stages of a bull market.

• The first, when a few forward-looking people begin to believe things will get better
• The second, when most investors realize improvement is actually taking place
• The third, when everyone concludes things will get better forever
  

I came up with the flip side, the three stages of a bear market:

• The first, when just a few thoughtful investors recognize that, despite the prevailing bullishness, things won’t always be rosy
• The second, when most investors recognize things are deteriorating
• The third, when everyone’s convinced things can only get worse
  

The pendulum cannot continue to swing toward an extreme, or reside at an extreme, forever (although when it’s positioned at its greatest extreme, people increasingly describe that as having become a permanent condition).

The Most Important Thing Is Combating Negative Influences

To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored.

The Most Important Thing is Contrarianism

Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates

I realized in 2008—and in retrospect it seems so obvious—that sometimes skepticism requires us to say, “no, that’s too bad to be true.”

The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left.

The Most Important Thing Is Finding Bargains

The raw materials for the process consist of

• a list of potential investments,
• estimates of their intrinsic value,
• a sense for how their prices compare with their intrinsic value, and
• an understanding of the risks involved in each, and of the effect their inclusion would have on the portfolio being assembled.
  

“investment is the discipline of relative selection.” That expression has stayed with me for thirty-five years. Sid’s simple phrase embodies two important messages. First, the process of investing has to be rigorous and disciplined. Second, it is by necessity comparative. Whether prices are depressed or elevated, and whether prospective returns are therefore high or low, we have to find the best investments out there. Since we can’t change the market, if we want to participate, our only option is to select the best from the possibilities that exist. These are relative decisions.

most investors extrapolate past performance, expecting the continuation of trends rather than the far-more-dependable regression to the mean. First-level thinkers tend to view past price weakness as worrisome, not as a sign that the asset has gotten cheaper.

To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do. After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.

The Most Important Thing Is Patient Opportunism

there aren’t always great things to do, and sometimes we maximize our contribution by being discerning and relatively inactive. Patient opportunism—waiting for bargains—is often your best strategy.

You tend to get better buys if you select from the list of things sellers are motivated to sell rather than start with a fixed notion as to what you want to own.

You’ll do better if you wait for investments to come to you rather than go chasing after them.

Investing is the greatest business in the world because you never have to swing. You stand at the plate; the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity. All day you wait for the pitch you like; then, when the fielders are asleep, you step up and hit it.

You want to take risk when others are fleeing from it, not when they’re competing with you to do so.

If a single holder is forced to sell, dozens of buyers will be there to accommodate, so the trade may take place at a price that is only slightly reduced. But if chaos is widespread, many people will be forced to sell at the same time and few people will be in a position to provide the required liquidity.

The key during a crisis is to be

• insulated from the forces that require selling and
• positioned to be a buyer instead.
  

To satisfy those criteria, an investor needs the following things:

• staunch reliance on value
• little or no use of leverage
• long-term capital
• a strong stomach.
  

Patient opportunism, buttressed by a contrarian attitude and a strong balance sheet, can yield amazing profits during meltdowns.

The Most Important Thing Is Knowing What You Don’t Know

Overestimating what you’re capable of knowing or doing can be extremely dangerous—in brain surgery, transocean racing or investing. Acknowledging the boundaries of what you can know—and working within those limits rather than venturing beyond—can give you a great advantage.

The Most Important Thing Is Having a Sense for Where We Stand

Why not simply try to figure out where we stand in terms of each cycle and what that implies for our actions?

When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into inaction or panic selling, we should become aggressive.

So look around, and ask yourself: Are investors optimistic or pessimistic?

The seven scariest words in the world for the thoughtful investor—too much money chasing too few deals—provided an unusually apt description of market conditions.

The Most Important Thing Is Appreciating the Role of Luck

At a given time in the markets, the most profitable traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists—because of the nature of randomness.

A good decision is one that a logical, intelligent and informed person would have made under the circumstances as they appeared at the time, before the outcome was known.

Several things go together for those who view the world as an uncertain place:

• healthy respect for risk
• awareness that we don’t know what the future holds
• an understanding that the best we can do is view the future as a probability distribution and invest accordingly
• insistence on defensive investing
• and emphasis on avoiding pitfalls.
  

To me that’s what thoughtful investing is all about.

The Most Important Thing is Investing Defensively

Charley Ellis took Ramo’s idea a step further, applying it to investments. His views on market efficiency and the high cost of trading led him to conclude that the pursuit of winners in the mainstream stock markets is unlikely to pay off for the investor. Instead, you should try to avoid hitting losers. I found this view of investing absolutely compelling.

even highly skilled investors can be guilty of mis-hits, and the overaggressive shot can easily lose them the match. Thus, defense—significant emphasis on keeping things from going wrong—is an important part of every great investor’s game.

Defense actually can be seen as an attempt at higher returns, but more through the avoidance of minuses than through the inclusion of pluses, and more through consistent but perhaps moderate progress than through occasional flashes of brilliance.

I don’t think many investment managers’ careers end because they fail to hit home runs. Rather, they end up out of the game because they strike out too often—not because they don’t have enough winners, but because they have too many losers.

They bet too much when they think they have a winning idea or a correct view of the future, concentrating their portfolios rather than diversifying.

They incur excessive transaction costs by changing their holdings too often or attempting to time the market.

And they position their portfolios for favorable scenarios and hoped-for outcomes, rather than ensuring that they’ll be able to survive the inevitable miscalculation or stroke of bad luck.

the more challenging and potentially lucrative the waters you fish in, the more likely they are to have attracted skilled fishermen.

Defensive investing sounds very erudite, but I can simplify it: Invest scared! Worry about the possibility of loss. Worry that there’s something you don’t know. Worry that you can make high-quality decisions but still be hit by bad luck or surprise events. Investing scared will prevent hubris; will keep your guard up and your mental adrenaline flowing; will make you insist on adequate margin of safety; and will increase the chances that your portfolio is prepared for things going wrong. And if nothing does go wrong, surely the winners will take care of themselves.

The Most Important Thing is Avoiding Pitfalls

A portfolio that contains too little risk can make you underperform in a bull market, but no one ever went bust from that; there are far worse fates.

Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them. Most investors would hope to not buy, or perhaps even to sell, when greed has driven a stock ’s price too high. But superior investors might sell it short in order to profit when the price falls. Committing the third form of error—e.g., failing to short an overvalued stock—is a different kind of mistake, an error of omission, but probably one most investors would be willing to live with.

The Most Important Thing Is Adding Value

I’m going to introduce two terms from investment theory. One is beta, a measure of a portfolio’s relative sensitivity to market movements. The other is alpha, which I define as personal investment skill, or the ability to generate performance that is unrelated to movement of the market.

A portfolio with a beta above 1 is expected to be more volatile than the reference market, and a beta below 1 means it’ll be less volatile. Multiply the market return by the beta and you’ll get the return that a given portfolio should be expected to achieve, omitting nonsystematic sources of risk. If the market is up 15 percent, a portfolio with a beta of 1.2 should return 18 percent (plus or minus alpha).

According to theory, then, the formula for explaining portfolio performance (y) is as follows: y = α + βx Here α is the symbol for alpha, β stands for beta, and x is the return of the market. The market-related return of the portfolio is equal to its beta times the market return, and alpha (skill-related return) is added to arrive at the total return (of course, theory says there’s no such thing as alpha).

I have yet to hear anyone explain convincingly why it’s important to beat the market when the market does well. No, in the good years average is good enough.

The Most Important Thing Is Pulling It All Together