6. The Most Important Thing Is… Recognizing Risk
“The received wisdom is that risk increases in the recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions.”
Recognizing risk often starts from understanding the risk as previously explained in Part I. When people are not afraid of risk they will have a tendency to accept that risk without adequately being compensated. When there is a lack of fear or skepticism, investors may purchase investments at high P/E multiples, EBITDA rates, cap rates or narrowing spreads, depending on the asset class.
When risk is viewed as “gone” it may be in itself a dangerous source of risk and a major contributor to bubbles we have experienced in the past. As Howard Marks views it and how I myself have come to view it, “The degree of risk present in the market derives from the behavior of the participants, not from the securities, strategies, and institutions. Regardless of what’s designed into market structures, risk will be low if investors behave prudently.”
Relating to prudency Warren Buffett has a famous quote most will have heard previously: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
Buffett is talking about the risk that participants are willing to undertake at given points in the investment cycle. A healthy and safe financial system should be built on skepticism, risk aversion, worry, distrust, agnostic views and awareness of participants' attitudes, as it would help reduce the risk participants may be willing to take.
As an influx of demand of increasingly risky assets commences, rates or returns are naturally driven down by price being bid up. Returns are finite and prices paid now may be borrowing from the future as the company “grows into” the multiples it was assigned by eager investors. When viewing a capital markets line with various asset classes from (perceived to be) less risky, to most risky participants may be pushed to higher returns or "reaching for yield" and thus higher risk.
Money Market Funds, five-to-ten year treasuries, corporates, large cap equities, high yield or junk bonds, small cap equities, real estate, buyouts and venture capital are based on interest rates or the risk free rate of return in which an investor can earn. As rates are suppressed investors move up the capital markets line to obtain the same expected rate of return with higher risk thus lowering risk premiums. It is not about predicting the future risks but being aware of what is going on in the present. The market is responsive to investor behavior, actions and attitudes. It is not a market in which we operate but a market in which operates because of us. “The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it,” Marks says.
When lender reticence is on the rise, this may be the time in which the bargains are found. Credit cycles tend to follow economic cycles: reluctance to lend followed by gradual increases of lending followed by competitive lending and relaxed terms, and finally ending with tightening and reluctance to lend. When everyone believes something is risky, the reluctance usually ends up pushing prices to where there is almost no risk, as all positive outlook(s) have been beaten out of the price and there are relatively no or very few willing buyers.
As Buffett famously said, “It's only when the tide goes out that you find out who’s been swimming naked.” Marks added, “Pollyannas take note: The tide cannot come in forever.”[/b]
[b]7. The Most Important Thing Is… Controlling Risk
Loss and risk are two completely different things and as Marks puts it, losses generally only occur when risk collides with negative events, using the parable below for illustration purposes.
“Germs cause illness, but germs themselves are not illness. We might say illness is what results when germs take hold. Homes in California may or may not have construction flaws that would make them vulnerable to collapse during earthquakes. We only find out when earthquakes occur,” Marks says.
Skillful risk control is what separates superior long-lasting investors from the rest. Being protected from once-in-a-generation events may be the limit of how far one can see or adequately control risk due to all kinds of risk associated with investing. One of these is counter-party risk or the risk of not being paid what is rightfully yours due to liquidity constraints in bleak times.
Below are two charts depicting how an investor can add value above and beyond indexing through one of two ways. The first being by additional returns that is easily quantifiable, black or white, and the second being lowered risk, not easily quantifiable or even noticeable in positive times. It is only in negative times that absolute returns and limited risk taking goes noticed and congratulated. By removing yourself completely from risk, positive real rates of return cannot be achieved in the present environment of central bank easing. Normally 3% to 6% in Treasuries may suffice but I am sure no professional investor is in the business for 3% to 6%, or as Will Rogers said, “You’ve got to go out on a limb sometimes because that is where the fruit is.”
Knowing what you don’t know is a very important concept when dealing with risk: The more you are aware of what A) you don’t know and B) you can’t control, the more acceptable the risk levels will be when choosing investments.
(Chart 1 from “The Most Important Thing” by Howard Marks)
(Chart 2 from “The Most Important Thing” by Howard Marks)
8. The Most Important Thing Is… Being Attentive to Cycles
Rule No. 1: Most things will prove to be cyclical.
Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget rule one.
A famous saying most people have probably heard is, “Trees do not grow to the sky,” or, things cannot go on forever. “What comes up must go down,” and many other similar metaphors, are used universally. One of the most dangerous things an investor can do is extrapolate trends into the future while not being attentive of business, investment or credit cycles. Believing good performance will continue and bad events won't end, it may be difficult to judge exactly where we are in a cycle.
Through experience and education one may be able to draw similarities between past and present behavior and attitudes, thus be attentive to the present. The worst loans are made at the best of times when the economy is in optimistic growth mode, or as Marks says, “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, build and buy – often without discipline, and with very negative consequences.”
Most forecasts and predictions are completely wrong, as proven throughout history by simply searching through old newspaper articles, viewing previous events before hand and viewing the articles after the event. An example of this may be the outlook in 1929, 1999 or 2006 to 2007 (personal favorites) with most participants naively carrying on like “business as usual.” It is understanding the process of the cycles and how they are created and how they are subdued that is important, not forecasting what will happen six months or one year from now.
[i]“Cycles always prevail eventually.” – Howard Marks [/b]
[b]9. The Most Important Thing Is… Awareness of the Pendulum
“Investment markets follow a pendulum-like swing: between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced,” Marks says.
Using the analogy of the pendulum with fear and greed at each end, hypothetically the “average” should be the middle or where the pendulum would spend the most time. This unfortunately is not the case, as most of the time the pendulum is moving away from each end (fear or greed) and towards the other opposite. As it resides at one extreme, energy is built up and then released like a spring towards the other extreme, moving quicker towards the other extreme then when it had approached. Those who understand this behavior of the pendulum may benefit enormously. As Marks' partner, Sheldon Stone, likes to say, “The air goes out of the balloon much faster than it went it.”
The things we don’t know about the pendulum, much like a business cycle are: “how far the pendulum will swing in its arc, what might cause the swing to stop and turn back, when the reversal will occur or how far it will swing in the opposite direction.” [/b]
[b] 10. The Most Important Thing Is… Combating Negative Influences
“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, wide-spread, and reoccurring," Marks says.
Marks talks about six emotions that undermine the investment process: greed, fear, dismissal of logic, conformation to the view of the herd rather than resistance, ego and finally, envy.
47 Cognitive Biases Investors May Be Able To Exploit.
There are various cognitive biases that also influence and undermine the investment process that investors may be able to exploit, or at the very least, to be aware of the handicap they present. The emotions and biases may be studied, but there is no guarantee investors will thwart them. Oaktree uses the following arsenal of weapons when combating negative influences.
a) A strongly held sense of intrinsic value.
b) Insistence on acting as you should when prices diverge from value.
c) Enough conversance with past cycles – gained at first from reading and talking to veteran investors, and later through experience – to know that market excesses are ultimately punished, not rewarded.
d) A thorough understanding of the insidious effect of psychology on the investing process at market extremes.
e) A promise to remember that when things seem “too good to be true,” they usually are.
f) Willingness to look wrong while the market goes from mis-valued to more mis-valued.
g) Like-minded friends and colleagues from whom to gain support.
Hopefully the wisdom of Oaktree's Howard Marks will help you immensely, as it has me. His ideas of risk are tightly correlated with those of Nassim Taleb and his three books, "Fooled by Randomness," "Black Swan" and "AntiFragile." Keep on alert for both part III and part IIII of the series of articles and in the mean time, I recommend reading the memos below.
The 20 Most Important Things Proposed By Howard Marks (Part III Of IV).
Further Reading from Howard Marks:
1) Risk and Return Today
2) So Much That’s False and Nutty
3) You Can’t Predict You Can Prepare
4) The Happy Medium
About the author:
"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain