Howard Marks: What Is Investing Risk?

Value investor Howard Marks dives deep into risk

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Sep 26, 2022
Summary
  • Howard Marks is the billionaire founder and chairman of Oaktree Capital. 
  • In a 2022 presentation at Wharton, Marks outlines how he thinks about risk. 
  • The strategy of Oaktree Capital focuses on deep value assets such as distressed debt.
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Howard Marks (Trades, Portfolio) is a legendary value investor whose iconic memos are read by many great investors, including Warren Buffett (Trades, Portfolio) himself. Marks has a fascinating thought process and is great at explaining complex concepts in a way others can understand.

In a 2022 presentation at the Wharton School of Business, Marks explained how he believes investors should think about risk when investing in order to build wealth in the long term. Here are my takeaways from the presentation.

Why is understanding risk important?

Risk is the most important thing to understand when investing according to Marks, as the goal is to “make money and control risk." Thus if you understand the risk of an investment, you can understand the risk/reward tradeoff and ultimately whether or not you should invest.

Marks says investors should aim to make bets with an asymmetric risk profile. For example, a bet with a 300% potential return but only 20% downside would be great, as the goal is to “make more money than what you could lose."

Volatility is not risk

Traditional finance teaches that volatility, or Beta, which is how much a stock has moved up or down relative to its index, is a form of risk. However, Marks controversially believes it is not. He believes volatility can be an indicator of the presence of risk, “but is not risk itself.”

Quoting Albert Einstein, he said, “Not everything which counts can be counted and not everything which is counted counts."

Marks believes that risk is unquantifiable in advance. The future can be different from the past, so even using historical data has its limitations. Marks also says, “Risk is not quantifiable even after the fact.” For example, if you buy a stock for $100 per share and after you sell it for $200, was it risky? From the end result, it is very hard to tell how much risk you took. Was it a low-risk investment or a high-risk investment where you just got lucky?

Thus, as Marks said, "You can’t tell the quality of the decision purely on the result.” An analogy he has used in the past is to imagine walking through a dynamite factory with a lit match. If you survive and get to the other side you win $1 million, but if not you die. Let’s say Person A gets to the other side safely and is hailed a genius, but was this a good investment decision? On a risk/reward basis, this was not a good investment decision. “I would rather be approximately right than precisely wrong, said Marks.

What is risk?

If volatility is not risk, then what is risk? Marks defines risk as the probability of a permanent loss of capital. For example, a stock's price can fluctuate downwards temporarily, which is volatility but not necessarily risk.

Other types of risk include opportunity cost and selling at the bottom. Opportunity cost is the risk of losing out on potential returns from better investments. Also called the risk of missing out, this can also be labeled as the “risk that you didn’t take enough risk.”

Selling at the bottom refers to the risk of being forced out at the bottom. The market moves in a cycle around a trendline that is upward sloping. A bad enough decline can make people sell, as they may have lost confidence, but an often-overlooked factor is that when the economy is bad, investors may have to sell at the bottom in order to pay the bills.

We can model the different possibilities (best case, worst case, average case) and likelihood that they will occur. For example, I have developed Monte Carlo simulations that shows a distribution of outcomes. However, the risk from “black swan” events is still possible. This is the “long tail risk,” or the risk that “we don’t know what we don’t now."

Future is a probability distribution

The future should be viewed as a probability distribution according to Marks. This is true of investments and many things in life. “All knowledge is about the past and all decisions are about the future.”

The future should be viewed not as a fixed outcome that is destined to be predicted, but as a “range of outcomes." He gives the example of how Hillary Clinton had an 80% chance of winning the presidential election based on polls. However, Donald Trump won despite only having a 20% chance according to polls. Therefore, it’s clear that even seemingly unlikely scenarios can occur, especially if the yardstick you are using to measure potential outcomes leaves out key parts of the system that determines real results. In reality, most of our predictions are about as full of holes as using internet polls to try and predict an election outcome.

“Improbable things happen all the time, probable things fail to happen all the time," said Marks. A loss happens when the probability of loss collides with a negative event. For example, a house will construction flaws will stand until there is a rare earthquake.

Risk is not a function of asset quality

Surprisingly, Marks argues that risk is not a function of asset quality. For example, a high-quality company can be overpriced and thus risky. An example of this is the “Nifty Fifty” stocks of the 1960’s and 1970’s. These were classed as the 50 “best” and “fastest” growng companies. However, Marks points out that if you held them for five years, “you lost all your money." A common phrase on Wall Street was “nobody ever got fired for investing into IBM (

IBM, Financial)," as that was also seen as a “safe” blue chip stock. But again the company has steadily declined from its golden years.

Conversely, a “low-quality asset can be cheap enough to make it safe." An example of this is deep value stocks or the “junk bonds” Marks has invested into.

Dealing with risk

Risks should be dealt with consistently and not sporadically. Rather than a “risk off” and “risk on” mode it should be continuous assessments. An example is the purchase of car Insurance. If at the end of the year you didn’t have an accident, you don’t think that was a “waste." It’s the same with portfolio risk management. “Because of the presence of risk, things will be different than we expect from time to time. How well are we prepared to deal when it’s different?”

You can bear risk prudently if it is:

  • Risk you’re aware of.
  • Risk that can be analyzed.
  • Risk that can be diversified.
  • Risk you’re paid well to bear.

Risk is something to managed and controlled, “not avoided.” Outstanding investors are outstanding because they have a “superior” sense for the probability distribution governing future events and whether the gain compensates for the risks which lurk in a distribution's left hand tail. But it’s a hidden accomplishment most of the time, where risk only turns into loss occasionally.

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Disclosures

I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure
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