I like to say "Experience is what you get when didn't get what you wanted."

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…Investing can't be reduced to an algorithm and turned over to a computer. Even the best investors [or algorithms] don't get it right all the time. The reasons are simple. No rule always works. The environment isn't controllable and the circumstances rarely repeat exactly. Psychology plays a major role in markets and because it's highly variable, cause-and-effect relationships aren't reliable. An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed. And if others emulate an approach, that will blunt its effectiveness. Investing, like economics, is more art than science. And that means it can get a little messy.

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If prices in efficient markets already reflect the consensus, then sharing the consensus view will make you likely to earn just an average return. To beat the market you must hold and idiosyncratic, or nonconsensus, view.

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SETH KLARMAN: Psychological influences are a dominating factor governing investor behavior. They matter as much as—and at times more than—underlying value in determining securities prices.

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Whereas investors are supposed to be open to any asset—and to both owning it and being short—the truth is very different. Most professionals are assigned to particular market niches, as in “I work in the equity department” or “I’m a bond manager.” SETH KLARMAN: Silos are a double-edged sword. A narrow focus leads to potentially superior knowledge. But concentration of effort within rigid boundaries leaves a strong possibility of mispricings outside those borders. Also, if others’ silos are similar to your own, competitive forces will likely drive down returns in spite of superior knowledge within such silos.

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In the great debate over efficiency versus inefficiency, I have concluded that no market is completely one or the other. It’s just a matter of degree. I wholeheartedly appreciate the opportunities that inefficiency can provide, but I also respect the concept of market efficiency, and I believe strongly that mainstream securities markets can be so efficient that it’s largely a waste of time to work at finding winners there.

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Theory says high return is associated with high risk because the former exists to compensate for the latter. But pragmatic value investors feel just the opposite: They believe high return and low risk can be achieved simultaneously by buying things for less than they’re worth. In the same way, overpaying implies both low return and high risk.

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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.”

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There have been many efforts of late to make risk assessment more scientific. Financial institutions routinely employ quantitative “risk managers” separate from their asset management teams and have adopted computer models such as “value at risk” to measure the risk in a portfolio. But the results produced by these people and their tools will be no better than the inputs they rely on and the judgments they make about how to process the inputs. In my opinion, they’ll never be as good as the best investors’ subjective judgments.

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And that brings me to the quotation from Elroy Dimson that led off this chapter: “Risk means more things can happen than will happen.” Now we move toward the metaphysical aspects of risk.

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Understanding uncertainty: The possibility of a variety of outcomes means we musn't think of the future in terms of a single result but rather as a range of possibilities. The best we can do is fashion a probability distribution that summarizes the possibilities and describes their relative likelihood. We must think about the full range, not just the ones that are most likely to materialize. Some of the greatest losses arise when investors ignore the improbable possibilities.

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Bruce [Greenwald] has put it admirably into words: “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.

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For the most part, I think it’s fair to say that investment performance is what happens when a set of developments—geopolitical, macro-economic, company-level, technical and psychological—collide with an extant portfolio. Many futures are possible, to paraphrase Dimson, but only one future occurs. The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck.

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Projections tend to cluster around historic norms and call for only small changes. … The point is, people usually expect the future to be like the past and underestimate the potential for change.

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Controlling the risk in your portfolio is a very important and worthwhile pursuit. The fruits, however, come only in the form of losses that don’t happen. Such what-if calculations are difficult in placid times.

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The longer I’m involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself. The process is simple: 1) The economy moves into a period of prosperity. 2) Providers of capital thrive, increasing their capital base. 3) Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.  4) Risk averseness disappears. 5) Financial institutions move to expand their businesses—that is, to provide more capital. 6) They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction and easing covenants.   At the extreme, providers of capital finance borrowers and projects that aren’t worthy of being financed. As The Economist said earlier this year, “the worst loans are made at the best of times.”

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In Field of Dreams, Kevin Costner was told, “If you build it, they will come.” In the financial world, if you offer cheap money, they will borrow, buy and build—often without discipline, and with very negative consequences.

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When things are going well, extrapolation introduces great risk. Whether it’s company profitability, capital availability, price gains, or market liquidity, things that inevitably are bound to regress toward the mean are often counted on to improve forever.

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The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing—-these factors are near universal. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, widespread and recurring.

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Time and time again, the combination of pressure to conform and the desire to get rich causes people to drop their independence and skepticism, overcome their innate risk aversion and believe things that don’t make sense. However negative the force of greed might be, always spurring people to strive for more and more, the impact is even stronger when they compare themselves to others. This is one of the most harmful aspects of what we call human nature. People who might be perfectly happy with their lot in isolation become miserable when they see others do better. In the world of investing, most people find it terribly hard to sit by and watch while others make more money than they do.

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You need the ability to detect instances in which prices have diverged significantly from intrinsic value. You have to have a strong-enough stomach to defy conventional wisdom (one of the greatest oxymorons) and resist the myth that the market’s always efficient and thus right. You need experience on which to base this resolute behavior. And you must have the support of understanding, patient constituencies. Without enough time to ride out the extremes while waiting for reason to prevail, you’ll become that most typical of market victims: the six-foot-tall man who drowned crossing the stream that was five feet deep on average.

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Active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel. Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom.

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Certain common threads run through the best investments I’ve witnessed. They’re usually contrarian, challenging and uncomfortable—although the experienced contrarian takes comfort from his or her position outside the herd.

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Not only should the lonely and uncomfortable position be tolerated, it should be celebrated. Usually—and certainly at the extremes of the pendulum’s swing—being part of the herd should be a reason for worry.

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One of the great things about investing is that the only real penalty is for making losing investments. There’s no penalty for omitting losing investments, of course, just rewards. And even for missing a few winners, the penalty is bearable.

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I’m firmly convinced that (a) it’s hard to know what the macro future holds and (b) few people possess superior knowledge of these matters that can regularly be turned into an investing advantage. There are two caveats, however: 1) The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. 2) With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Thus, I suggest people try to “know the knowable.”

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Investment results will be determined entirely by what happens in the future, and while we may know what will happen much of the time, when things are “normal,” we can’t know much about what will happen at those moments when knowing would make the biggest difference.

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Whatever limitations are imposed on us in the investment world, it’s a heck of a lot better to acknowledge them and accommodate than to deny them and forge ahead. Oh yes; one other thing: the biggest problems tend to arise when investors forget about the difference between probability and outcome—that is, when they forget about the limits on foreknowledge: when they believe the shape of the probability distribution is knowable with certainty (and that they know it), when they assume the most likely outcome is the one that will happen, when they assume the expected result accurately represents the actual result, or perhaps most important, when they ignore the possibility of improbable outcomes.

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Investing in an unknowable future as an agnostic is a daunting prospect, but if foreknowledge is elusive, investing as if you know what’s coming is close to nuts. Maybe Mark Twain put it best: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

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It would be wonderful to be able to successfully predict the swings of the pendulum and always move in the appropriate direction, but this is certainly an unrealistic expectation. I consider it far more reasonable to try to (a) stay alert for occasions when a market has reached an extreme, (b) adjust our behavior in response and, (c) most important, refuse to fall into line with the herd behavior that renders so many investors dead wrong at tops and bottoms.

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When buyers compete to put large amounts of capital to work in a market, prices are bid up relative to value, prospective returns shrink, and risk rises. It’s only when buyers predominate relative to sellers that you can have highly overpriced assets. The warning signs shouldn’t be hard to spot.

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The lender who insists on margin for error and lends only to strong borrowers will experience few credit losses. But this lender’s high standards will cause him or her to forgo lending opportunities that will go to lenders who are less insistent on creditworthiness. The aggressive lender will look smarter than the prudent lender (and make more money) as long as the environment remains salutary. The prudent lender’s reward comes only in bad times, in the form of reduced credit losses. The lender who insists on margin for error won’t enjoy the highest highs but will also avoid the lowest lows. That’s what happens to those who emphasize defense.

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Of the two ways to perform as an investor—racking up exceptional gains and avoiding losses—I believe the latter is the more dependable.

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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.

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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.

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The markets are a classroom where lessons are taught every day. The keys to investment success lie in observing and learning.

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[Some of Marks's observations]:  1) Too much capital availability makes money flow to the wrong places. 2) When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error. 3) Widespread disregard for risk creates great risk. 4) Inadequate due diligence leads to investment losses. 5) In heady times, capital is devoted to innovative investments, many of which fail the test of time. 6) Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem. 7) Psychological and technical factors can swamp fundamentals 8)  Markets change, invalidating models. 9) Leverage magnifies outcomes but doesn’t add value. 10) Excesses correct.

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Loss of confidence and resolve can cause investors to sell at the bottom, converting downward fluctuations into permanent losses and preventing them from participating fully in the subsequent recovery. This is the greatest error in investing—the most unfortunate aspect of pro-cyclical behavior—because of its permanence and because it tends to affect large portions of portfolios.

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When the salesman on the phone offers you a guaranteed route to profit, you should wonder what made him offer it to you rather than hog it for himself. Likewise, but a little more subtly, if an economist or strategist offers a sure-to-be-right view of the future, you should wonder why he or she is still working for a living, since derivatives can be used to turn correct forecasts into vast profits without requiring much capital.

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The psychology of the investing herd moves in a regular, pendulum-like pattern—from optimism to pessimism; from credulousness to skepticism; from fear of missing opportunity to fear of losing money; and thus from eagerness to buy to urgency to sell. The swing of the pendulum causes the herd to buy at high prices and sell at low prices. Thus, being part of the herd is a formula for disaster, whereas contrarianism at the extremes will help to avert losses and lead eventually to success.

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Risk control and margin for error should be present in your portfolio at all times. But you must remember that they’re “hidden assets.” Most years in the markets are good years, but it’s only in the bad years—when the tide goes out—that the value of defense becomes evident. Thus, in the good years, defensive investors have to be content with the knowledge that their gains, although perhaps less than maximal, were achieved with risk protection in place … even though it turned out not to be needed.

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