Below is Part 4 of PM Jar’s interview with Howard Marks, the co-founder and chairman of Oaktree Capital Management, on portfolio management. Part 4: The Art of Transforming Symmetry into Asymmetry

“If tactical decisions like concentration, diversification, and leverage are symmetrical two-way swords, then where does asymmetry come from? Asymmetry comes from alpha, from superior personal skill.”

Marks: Everything in investing is a two-way sword – a symmetrical two-way sword. If you turn cautious and raise cash, it will help you if you are right, and hurt you if you are wrong. If tactical decisions like concentration, diversification, and leverage are symmetrical two-way swords, then where does asymmetry come from? Asymmetry comes from alpha, from superior personal skill.

Superior investors add value in a number of ways, such as security selection, knowing when to drop down in quality and when to raise quality, when to concentrate and when to diversify, when to lever and when to delever, etc. Most of those things come under the big heading of knowing when to be aggressive and when to be defensive. The single biggest question is when to be aggressive and when to be defensive.

I believe very strongly that investors have to balance two risks: the risk of losing money and the risk of missing opportunity. The superior investor knows when to emphasize the first and when to emphasize the second – when to be defensive (i.e., to worry primarily about the risk of losing money) and when to be aggressive (i.e., to worry primarily about the risk of missing opportunity). In the first half of 2007, you should have worried about losing money (there was not much opportunity to miss). And in the last half of 2008, you should have worried about missing opportunity (there wasn’t much chance of losing money). Knowing the difference is probably the most important of all the important things.

PM Jar: How do you think about the opportunity cost when balancing these two risks? Is it historical or forward looking?

Marks: If you bought A, your opportunity cost is what you missed by not holding B. That’s historical. Similarly, when you look forward, you can take an infinite number of different actions in putting together your portfolio.Opportunity cost is what you could lose by doing what you’re doing, as opposed to other things that you could have done.

Opportunity cost is a sophisticated sounding way to address the risk of doing something versus the risk of not doing it. This is how we decide whether and how to invest: If I buy it, could I lose money? If I don’t buy it, could I miss out on something? If I buy a little, should I have bought a lot? If I bought a lot, should I have bought a little?

Investing is an art form in the sense that it can’t be mechanized. There is no formula or rule that works – it’s all feel. You get the inputs, analyze them, turn the crank, get numbers out – but they are only guesswork. Anything about the future is only a guess. The best investing is done by people who make the best subjective judgments.

Anyone who thinks they are going to make all decisions correctly is crazy. But if you make mistakes, you have to learn from them. Otherwise you’re making another huge mistake if you ignore the learning opportunity. One of my favorite sayings is, “Experience is what you got when you didn’t get what you wanted.”

Continue Reading — Part 5 of 5: Creating Your Own Art