Looking for returns is just one part of the investment equation. An equally important aspect of the process is defining your risk. Howard Marks (Trades, Portfolio) knows all about balancing risk and reward. Standard financial theory states that risk and reward is always balanced: the higher the return offered by an asset, the higher its implied risk. But a key tenet of Marks' investment strategy is that it is possible to find stocks and bonds of businesses where the return outweighs the risk significantly. In a talk at the UCLA Fink Center, Marks explained how investors should define their own risk.
What’s your risk?
Marks believes that risk appetites exist on a spectrum. On one end of the spectrum is total risk aversion. An investor on this end will be entirely in cash and will shy away from even the most conservative investment, except for maybe U.S. Treasury bonds. On the other end of the spectrum is unlimited risk appetite. This investor is willing to buy any asset - regardless of risk - that promises a superior return, potentially even with the use of margin.
Needless to say, most people fall somewhere in the middle of this metaphorical speedometer most of the time. One of the big challenges in investing is figuring out where to position oneself on this spectrum at different points in time:
“The first step that everyone who considers investing should take is to say: “From zero to 100: how am I? Given my age, financial position, my income, my requirements, my dependents, my psyche - where should I normally be? If you’re young and you have a great career, and you have more money than you need and if you have no dependents, and if you have the mistake in investing you have the time to make it right - then you can be 80 or 90 [on the zero to 100 scale].
On the other hand, Marks said that If you’re a person approaching retirement and you have a dependent spouse and you’re not going to have a job any more, and if you’re concerned about your ability to deal with the emotional impact of the market’s fluctuations, then you will probably be much lower on his scale - perhaps closer to 30 out of 100.
So in addition to figuring out the risk of an individual investment, an investor needs to figure out what their own personal risk tolerance is. This will depend on their personal circumstances, but in general can be summarised by the examples that Marks gave in his talk.
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