Wyandanch Library

Overview

Howard Marks' memos to Oaktree Capital clients, written over more than three decades, are among the most respected practitioner writings in the investment world. In these memos, Marks develops and refines his thinking on risk, market cycles, investor psychology, and the concept of "second-level thinking" -- the idea that successful investing requires thinking differently and better than the consensus, not just knowing more facts. The memos were later distilled into his book The Most Important Thing, but the original letters contain a richness and immediacy that the book cannot fully capture.

Marks is a credit investor by training, and his perspective on risk is particularly distinctive. He argues that risk is not volatility but the probability of permanent capital loss, and that the greatest risk arises when investors believe there is no risk. His analysis of market cycles -- the pendulum swinging between fear and greed, between risk tolerance and risk aversion -- provides a practical framework for understanding where we stand in any given market environment and how to position accordingly.

Second-Level Thinking

The concept that runs through everything Marks has written is the distinction between first-level thinking and second-level thinking. This is not about intelligence -- it's about depth.

First-level thinking is simple, surface-level, and shared by most market participants:

"This is a good company, let's buy the stock."
"The economy is slowing, sell everything."
"Inflation is rising, buy gold."
"This company just beat earnings, it's going higher."

Second-level thinking asks the next question -- and the question after that:

"This is a good company, but everyone knows it's a good company, so it's priced for perfection. The expected return is low and the downside risk is high if anything disappoints."
"The economy is slowing and everyone is panicking. But the panic has driven prices below intrinsic value. The expected return from buying here is actually excellent."
"This company beat earnings, but the beat was driven by one-time items and the guidance was weak. The market is celebrating on the surface, but the underlying business is deteriorating."

The critical insight is that consensus thinking produces consensus returns. If your analysis leads to the same conclusion as everyone else's, that conclusion is already reflected in the price. To earn above-average returns, you need a view that is both different from the consensus and correct. Being different and wrong is catastrophic. Being the same and right is mediocre. Only the intersection of different and right produces superior results.

Marks illustrates this with a simple matrix:

	Consensus is Right	Consensus is Wrong
You Agree	Average return	Average loss
You Disagree	Below-average return	Above-average return

The only box that produces above-average returns is the bottom-right: the consensus is wrong, and you correctly disagree. This is the entire game of active management. It's also why it's so hard -- you have to be right precisely when most people are wrong, which means you will often feel uncomfortable, lonely, and uncertain.

Risk is Not Volatility

Marks' treatment of risk is perhaps his most important contribution to investment thinking. He flatly rejects the academic definition of risk as volatility (standard deviation of returns) and replaces it with a practitioner's definition: risk is the probability of permanent capital loss.

A stock that drops 50% and recovers is volatile but not risky in any meaningful sense -- as long as you held on. A stock that drops 50% and never recovers has destroyed your capital permanently. A bond that defaults is risky. A Treasury bill that fluctuates in market value is not. Academic finance conflates these situations by measuring risk as price variability, which Marks considers fundamentally misleading.

The Risk Paradox

Marks' deepest insight about risk is counterintuitive: risk is highest when the perception of risk is lowest.

When investors feel safe, they bid up prices, accept lower risk premiums, use more leverage, and buy lower-quality assets. The very behavior that reflects low perceived risk creates high actual risk. Conversely, when investors are terrified, they dump assets, demand high risk premiums, and avoid anything uncertain. The behavior that reflects high perceived risk creates low actual risk, because prices have fallen to levels that provide a large margin of safety.

This is why the worst losses tend to come from investments made during "good times" -- when credit spreads are tight, volatility is low, and everyone agrees the economy is strong. And the best returns tend to come from investments made during panics -- when spreads are wide, volatility is high, and everyone agrees the world is ending.

The Risk-Return Relationship

Academic finance teaches that higher risk produces higher return -- the "risk-return tradeoff." Marks argues this is dangerously misleading. The correct statement is: higher risk produces higher expected return -- meaning the range of outcomes is wider, not that the outcome will necessarily be good.

A risky investment might return +40% or -30%, averaging +5%. A safe investment might return +5% to +7%, averaging +6%. The risky investment has a higher potential return but also a higher potential loss, and the average return may actually be lower. Risk does not guarantee reward. It guarantees uncertainty. This distinction matters enormously for portfolio construction and is one of the reasons Marks emphasizes defensive investing so heavily.

Market Cycles: The Pendulum

Marks uses the metaphor of a pendulum to describe market psychology. The pendulum swings between two extremes:

Euphoria: risk tolerance is high, skepticism is low, asset prices are inflated, credit is freely available, and investors compete to take on more risk. "There's nothing to worry about."
Panic: risk aversion is high, skepticism is excessive, asset prices are depressed, credit is unavailable, and investors compete to reduce exposure. "There's no way out."

The pendulum spends very little time at the midpoint -- the area of balance, reasonable risk assessment, and fair pricing. It is almost always swinging toward one extreme or the other. Marks' practical framework is to estimate where we are in the cycle and position accordingly:

When the pendulum is near the euphoria extreme, reduce risk exposure. The expected return on risky assets is low (because prices are high) and the probability of a downturn is elevated.
When the pendulum is near the panic extreme, increase risk exposure. The expected return on risky assets is high (because prices are depressed) and the probability of recovery is elevated.

This sounds simple, but it requires the psychological fortitude to buy when everyone is selling and reduce exposure when everyone is making money. It means looking foolish for extended periods. It means being early, which is indistinguishable from being wrong until the cycle turns.

Reading the Cycle

Marks offers specific indicators for assessing where we are:

Credit availability: When banks are lending freely and covenants are loose, we're late in the cycle. When credit markets freeze and only the best borrowers can access capital, we're near the bottom.
Investor behavior: When investors are fighting to get into deals and waiving due diligence, euphoria is high. When investors refuse to look at opportunities at any price, panic is high.
Risk premiums: When the spread between risky and safe assets is narrow, risk is being underpriced. When spreads are wide, risk is being overpriced.
Leverage: Increasing leverage across the system is a late-cycle indicator. Forced deleveraging is a crisis indicator.

Contrarian Investing

Marks is a thoughtful contrarian -- not reflexively contrarian, but selectively so. He argues that going against the crowd is necessary for outperformance but not sufficient. Being contrarian just for the sake of being contrarian is as foolish as following the crowd.

The key is to be contrarian when the crowd is wrong and you understand why. This requires:

Independent analysis: You must have a well-reasoned view of intrinsic value that does not depend on what others think.
Understanding of sentiment: You must be able to assess whether the consensus view has pushed prices away from fair value.
Emotional discipline: You must be willing to act on your analysis even when it feels terrible -- buying into a crash, selling into a rally.

Marks frequently quotes his mentor: "Being too far ahead of your time is indistinguishable from being wrong." The contrarian investor must have both the conviction to act and the staying power to wait for the thesis to play out.

Luck vs. Skill

One of Marks' most intellectually honest discussions involves the relationship between luck and skill in investing. He argues that investment results are always a combination of both, and that distinguishing between them is extremely difficult.

A great outcome doesn't prove the decision was skillful. A terrible outcome doesn't prove the decision was unskillful. In a probabilistic activity, the quality of a decision can only be judged by the quality of the process, not the outcome. A poker player who goes all-in with aces and loses to a lucky river card made the right decision despite the bad outcome.

Marks' framework:

In the short run, luck dominates. A monkey throwing darts can outperform a brilliant analyst over any six-month period.
In the long run, skill dominates. Over decades, the disciplined investor with superior process will outperform, because luck averages out while skill compounds.
The biggest danger is confusing luck for skill. Investors who mistake a bull market for personal genius will take increasingly reckless risks until the market humbles them.

This has profound implications for evaluating investment managers. A three-year track record tells you almost nothing about skill. Even a ten-year record may be dominated by the market environment. Marks suggests focusing on how someone invests -- their process, risk controls, and intellectual framework -- rather than what their returns have been.

Knowing What You Don't Know

Marks draws a critical distinction between two types of investors:

"I know" investors: They believe they can predict the macro future -- interest rates, GDP growth, election outcomes, geopolitical events. They make large, concentrated bets on these predictions.
"I don't know" investors: They acknowledge radical uncertainty about the macro future and focus on bottom-up value assessment, diversification, and risk control.

Marks firmly places himself in the "I don't know" camp. He argues that macro forecasting has an abysmal track record and that the investors who claim to know the future are either lucky or deluded. The honest investor acknowledges uncertainty and builds portfolios that can withstand a range of outcomes rather than betting on a single predicted outcome.

This doesn't mean you can't have views. It means you should size your bets in proportion to your confidence, maintain adequate diversification, and always ask: "What if I'm wrong?"

Defensive vs. Offensive Investing

Marks distinguishes between two investment approaches:

Offensive investing focuses on maximizing gains: finding the biggest winners, concentrating in high-conviction ideas, using leverage to amplify returns. When it works, it produces spectacular results. When it doesn't, losses can be devastating.

Defensive investing focuses on minimizing losses: avoiding the worst investments, diversifying adequately, demanding a margin of safety, and ensuring that even in bad scenarios, the portfolio survives. It will never produce the biggest gains in a bull market, but it will avoid the worst losses in a bear market.

Marks argues that defense is more important than offense for most investors, for a mathematically simple reason: losses are harder to recover from than gains. If you lose 50%, you need a 100% gain just to get back to even. Avoiding large losses is more valuable than capturing large gains, because it keeps your capital base intact for compounding.

In Marks' formulation: "There are old investors, and there are bold investors, but there are no old, bold investors."

Why This Matters

Marks' memos are essential reading for anyone managing capital in public or private markets. His frameworks for thinking about risk, cycles, and contrarian positioning are directly applicable to portfolio construction and risk management. In a world where most investors are trapped in consensus thinking, Marks' emphasis on second-level thinking and cycle awareness offers a genuine edge.

The memos also serve as a real-time record of how a great investor thinks through uncertainty. Reading them in chronological order -- through the dot-com bust, the financial crisis, the post-crisis recovery, and the pandemic -- reveals how consistently Marks applied his framework, even when the specific circumstances were unprecedented. That consistency is the proof that the framework works.

Key Takeaways

Second-level thinking: to outperform, you must have a view that is both different from the consensus and correct -- simply agreeing with the crowd produces average results.
Risk is not volatility -- it is the probability of permanent loss, and it is highest when perceived risk is lowest.
Market cycles are driven by psychology: the pendulum swings between euphoria and panic, and understanding where you are in the cycle is critical to positioning.
The relationship between risk and return is not linear -- higher risk means a wider range of outcomes, not a guaranteed higher return.
Contrarian investing requires not just going against the crowd, but understanding why the crowd is wrong and having the staying power to wait.
In the short run, luck dominates results; in the long run, skill dominates. Judge process, not outcomes.
Knowing what you don't know is more valuable than pretending you know what you don't -- size bets in proportion to confidence.
Defensive investing (avoiding losers) is often more important than offensive investing (finding winners), because losses are mathematically harder to recover from.

Oaktree Capital Memos