Reminder From Howard Marks: Crucial to Know Where We Are in Market Cycle

Uncertainty itself is a rare certainty in investing.

Tim’s corporate finance professor at Columbia once invited legendary investor Howard Marks, founder of Oaktree Capital, as a guest lecturer. Marks shared that “dealing with risk and understanding where we are in the cycle are really the two keys to success.” Market cycles, the booms and busts, present an ever-present risk to your portfolio. Each cycle may be different in detail, but an investor who has studied past market performances will know that certain patterns can reveal themselves cycle after cycle. How do you learn about cycles? Charlie Munger said, “There’s no better teacher than history in determining the future.” Knowing the cycles does not give you complete certainty, but an investor who knows the history behind cycles can tip the odds in her favor.

A good investor should also understand psychology. Because human nature hardly changes, emotions will more often than not be a big component of trends. An investor cannot know the future, but she must have a rough idea of where the market is in the cycle to position herself accordingly and reduce the potential downsides. In his book Mastering the Market Cycles, Marks introduces the three stages of the bull market:

In Stage One: Accumulation, “only a few unusually perceptive people believe things will get better.” So, almost no one is investing, out of fear or indifference (e.g., post-Depression between 1930 and 1940, 2001, or 2009). In Stage Two: Markup, “most investors realize that improvement is actually taking place.” The market ticks upwards as more people turn bullish. In Stage Three: Distribution, “everyone concludes things will get better forever.” FOMO (Fear of Missing Out) sets in, greed takes over, and the market rises until the bubble pops. Every bull market inevitably must end and go into a bear market; in hindsight, it is relatively easy to see cycles at work.

The problem is that, in the heat of the moment, investors do not know which way the market will go—this is represented by the dotted lines in the graph. You know the economy will grow along the long-term growth line, but the market can go in any direction: up, flat or down in the short term. You can only say in probabilistic terms, never definitely, whether the market will grow or collapse in the near future. “Investing is not black or white, in or out, risky or safe.