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Warren Buffett once noted that "an investor needs do very few things right as long as he avoids big mistakes."
Howard Marks echoed this sentiment when he said, "trying to avoid losses is more important than striving for great investment successes."
While many investors focus on finding the next big winner, superior investors know a different truth: avoiding investment pitfalls is often the key to long-term success.
In this post, we’ll discuss investment pitfalls and how to avoid them. We’ll cover common errors, market psychology, risk assessment, and practical lessons from the 2008 financial crisis—all drawn from Howard Marks' 2011 book "The Most Important Thing."
📜 Howard Marks
Howard Marks co-founded Oaktree Capital Management in 1995, growing it into a firm managing over $180 billion in AUM. His distressed debt strategies, focused on investing in “good companies with bad balance sheets,” have delivered ~19% annual returns before fees for over 25 years. Marks is also renowned for his insightful investment memos.
Types of Investment Errors
Howard Marks identifies two primary categories of mistakes investors make:
Analytical/intellectual errors: These include collecting too little information, using incorrect information, applying the wrong analytical processes, or making calculation mistakes.
Psychological/emotional errors: These include succumbing to greed, fear, envy, ego, or conformity when making investment decisions.
Marks also highlights another important pitfall that doesn't fit neatly into either category: the failure to recognize market cycles and manias and move in the opposite direction.
While these extreme market swings don't happen often, they cause the largest errors. The power of herd psychology to push investors toward conformity can be very strong, which is why it's important that investors maintain their independence from these forces.
While both main types of errors can damage your portfolio, Marks particularly emphasizes an aspect of analytical error he calls "failure of imagination" - the inability to conceive the full range of possible outcomes or to understand the consequences of extreme events.
"Things that aren't supposed to happen do happen," Marks writes. "Short-run outcomes can diverge from the long-run probabilities, and occurrences can cluster."
The 2008 financial crisis showed how dangerous this blind spot can be. Financial products tied to mortgages were built on a key assumption - that home prices wouldn't fall across the entire country at once. This belief existed only because such a decline hadn't occurred in recent recorded history.
The Dilemma of Protection
This raises an important question for investors: How much time and capital should you devote to protecting against improbable disasters?
As Marks explains, you could insure against every extreme outcome - both deflation and hyperinflation - but doing so would be costly and would detract from investment returns when that protection isn't needed (which is most of the time).
For example, you could structure your portfolio to withstand another 2008-style crash, but that would mean holding mostly Treasuries, cash, and gold. For investors seeking meaningful long-term growth, this approach simply isn't practical.
Marks suggests a middle path: be aware of potential pitfalls and take reasonable precautions, but recognize that the right balance varies for each investor based on their goals, time horizon, and risk tolerance.
Asset Correlation Risk
Another aspect of failure of imagination involves not understanding asset correlation risk - how assets move in relation to each other, especially during market stress. As Marks writes:
"Understanding and anticipating the power of correlation - and thus the limitations of diversification - is a principal aspect of risk control and portfolio management, but it's very hard to accomplish."
He explains that investors often fail to appreciate the common threads running through their portfolios:
"Everyone knows that if one automaker's stock falls, factors they have in common could make all auto stocks decline simultaneously. Fewer people understand the connections that could make all U.S. stocks fall, or all stocks in the developed world, or all stocks worldwide, or all stocks and bonds, etc."
Some skeptics of the 2008 financial crisis, for instance, may have suspected subprime mortgages would default in large numbers, but few anticipated that the ramifications would spread far beyond the mortgage market to commercial paper, money market funds, and even cause the collapse of major financial institutions.
Psychological Forces in Investing
Market distortions created by psychological forces present three potential errors for investors:
Succumbing to them: Joining the crowd in being too greedy or fearful.
Participating unknowingly: Investing in markets distorted by others' emotions.
Failing to take advantage: Not capitalizing when these distortions create opportunities.
The first error happens when investors get caught up in market euphoria (e.g., buying tech stocks in 1999) or panic (e.g., selling everything in March 2020).
The second occurs when investors might not realize they're investing in a bubble - like many who bought houses in 2006-2007 simply because they needed a place to live, not realizing prices were artificially inflated.
The third form of error - missing opportunities when others panic - is one that superior investors work hard to avoid:
"Average investors are fortunate if they can avoid pitfalls, whereas superior investors look to take advantage of them."
When psychological forces like greed push prices too high, most investors focus on not buying overvalued assets. But superior investors go further by actively shorting these overpriced securities. Similarly, when fear drives prices below true value, average investors might simply avoid selling while superior investors aggressively buy.
For example, during market crashes like 2008-2009, panic selling pushed many good companies to trade at fractions of their intrinsic value. Investors who recognized this gap between price and value were able to make extraordinary returns in the subsequent recovery.
Marks emphasizes that these psychological swings are predictable parts of market cycles. They create the very inefficiencies that allow skilled investors to outperform the market over time.
Three Key Behavioral Pitfalls
Marks identifies three key behavioral pitfalls that commonly lead investors into mistakes (building on the psychological forces discussed above):
Pro-Cyclical vs. Countercyclical Behavior
The first key pitfall connects directly to the psychological forces mentioned earlier.
Most investors follow pro-cyclical behavior—buying when markets rise and selling when they fall. This feels comfortable but may lead to buying high and selling low.
The more successful approach is countercyclical investing—going against market trends by being greedy when others are fearful and fearful when others are greedy. Though psychologically difficult, this approach is key to superior investment returns.
Errors of Commission vs. Omission
Marks makes an important distinction between different types of investment errors:
Errors of commission: Occur when you actively do something wrong, such as buying an overvalued stock or using excessive leverage during a bubble.
Errors of omission: Happen when you fail to do something right, such as not buying excellent companies during a market crash or missing opportunities in unfamiliar sectors.
Most investors worry more about errors of commission because they're more visible and painful in the short term. However, errors of omission can be just as costly to long-term returns.
Marks also points out that sometimes there's no glaring error to be made because markets are at equilibrium and prices fairly reflect value. However, he still warns:
"When there's nothing particularly clever to do, the potential pitfall lies in insisting on being clever.”
The "It's Different This Time" Trap
One of the most dangerous psychological errors investors make is accepting novel rationales during market bubbles. Marks warns that in bullish markets, inadequate skepticism leads investors to believe that:
Some new development will change everything (e.g., internet in the late 1990s).
Traditional business cycles no longer apply.
Standard valuation metrics are outdated.
Credit risks have been eliminated through financial innovation.
These "this time is different" arguments appear sophisticated and appeal to our desire to participate in new opportunities. The reality, however, is that fundamental economic principles rarely change.
During the housing bubble, many believed nationwide home prices couldn't fall simultaneously. In the dot-com bubble, investors thought internet companies didn't need profits. In both cases, these beliefs were proven catastrophically wrong.
Marks emphasizes that maintaining healthy skepticism toward such claims is essential for avoiding bubble-related losses.
Note: We may be seeing these patterns in today's AI stocks, where investors pay high prices assuming massive profits that may take years to materialize—or never appear at all.
Lessons From the 2008 Crisis
The financial crisis of 2007-2008 provided timeless insights in investment pitfalls. Marks distilled eleven key lessons that remain valuable for all market environments:
Too much capital availability makes money flow to the wrong places. When capital is scarce, investors make allocation choices carefully. When too much capital chases too few ideas, poor investments get funded.
When capital goes where it shouldn't, bad things happen. Unqualified borrowers receive money they can't repay, leading to delinquencies and losses.
Capital oversupply leads investors to accept low returns and slim margins for error. Competition for deals pushes prices up and expected returns down.
Widespread disregard for risk creates great risk. When investors believe "nothing can go wrong," they take excessive risks that eventually lead to losses.
Inadequate due diligence leads to investment losses. In hot markets, investors worry about missing out rather than losing money, and careful analysis gets overlooked.
In heady times, capital flows to innovative investments that often fail. Eager investors accept new products they don't understand, only to regret it later.
Hidden fault lines in portfolios can make unrelated assets move together. Correlation is often underestimated, especially during crises when factors like margin calls and frozen markets affect everything similarly.
Psychological and technical factors can swamp fundamentals. In the short run, confidence matters more than underlying business quality.
Markets change, invalidating models. Computer models based on historical patterns fail when market dynamics shift.
Leverage magnifies outcomes but doesn't add value. Using leverage to buy overpriced assets is particularly dangerous.
Excesses correct. When markets are "priced for perfection," capital destruction often follows.
These lessons reveal the underlying patterns that drive market cycles. Marks captures their essence in a single key insight:
"Most of these eleven lessons can be reduced to just one: be alert to what's going on around you with regard to the supply/demand balance for investable funds and the eagerness to spend them."
How to Avoid Investment Pitfalls
Leading up to the financial crisis, what could investors have done? Marks suggests several protective strategies:
Taking note of the carefree behavior of others
Preparing psychologically for a downturn
Selling riskier assets
Reducing leverage
Raising cash (e.g., increasing money market or high-quality short-term bond allocations)
Generally tilting portfolios toward defensiveness
While almost nothing performed well in 2008, these defensive strategies could have helped investors lose less than others and reduce pain.
The Power of Relative Outperformance
Marks places special emphasis on the value of losing less than others during downturns. This relative outperformance delivers two key benefits that go beyond just preserving capital:
Psychological resilience: Investors who lose less maintain better emotional control during market turmoil. They avoid the panic that leads to selling at the worst possible moment—a critical advantage when markets are most volatile.
Buying power when it matters most: Investors who preserve capital during crashes have the financial capacity to purchase quality assets at bargain prices. These crisis-period investments often deliver the highest returns of an investor's career.
Marks notes that while absolute returns attract more attention, relative performance during downturns often determines long-term investing success.
Thanks for Reading!
