Howard Marks on Risk Avoidance

I think Howard Marks' (Trades, Portfolio) regular memos are some of the most underappreciated documents in the investment world. Everyone is familiar with Warren Buffett (Trades, Portfolio) and his letters to investors, but Marks' correspondence does not dominate the headlines in the same way.

I think it should.

Over the years this value investor has issued a constant stream of invaluable advice on how to reduce risk and invest sensibly throughout all market environments.

• SPY 30-Year Financial Data
• The intrinsic value of SPY
• Peter Lynch Chart of SPY

Marks on warning flags

In 2010, Marks published a memo titled "Warning Flags" in which he outlined several troubling developments that were occurring in the market at the time.

"I’ve been sharing my realization that there are two main risks in the investment world: the risk of losing money and the risk of missing opportunity. You can completely avoid one or the other, or you can compromise between the two, but you can’t eliminate both," the letter started.

In the current market environment, I think this advice is more critical than it has been at any other time during the past decade. After 10 years of steady stock market gains and asset inflation, it could be said that many investors have lost sight of their primary goal: to protect and grow their capital.

Marks' memo might have been a few years early, but it seems to hit the nail on the head when it comes to predicting investor sentiment and the role emotion has for so many investors. "Why do people buy when they should sell, and sell when they should buy?" he asks before answering, "The answer’s simple: emotion takes over. Price increases excite investors and encourage them to buy, and price declines scare them into selling."

Don't be emotional

In the current market environment, it is easy to let emotion take over your trading and investing decisions. In the past few weeks, a year's worth of gains on the S&P 500 have been erased. For the Russell 2000, two years' worth of profits have been eliminated in just a few months. Even for the most seasoned investor, this kind of turbulence is difficult to ignore.

Marks' memo described that "risk aversion is essential in order for markets to function properly." When sufficient risk aversion is present, people avoid risky investments and move their money into perceived safe havens. However, when asset prices are rising, investors are lulled into a false sense of security that leads them to expand their risk tolerance.

As Marks noted, "In the same way that expanded risk tolerance accompanies appreciated asset prices and contributes to the risk of loss, so does risk aversion tend to rise in times of depressed prices, increasing the risk of missed opportunity."

We've seen both sides of this debate play out over the past decade. Investors have been lulled into a false sense of security with low-interest rates, and have expanded their risk tolerances. Meanwhile, investors have been avoiding companies they perceive as risky, which in this case is old world businesses. On the other hand, they have been willing to pay top dollar for unproven, early stage tech companies.

Strict risk avoidance

Now that volatility has returned, it is imperative for investors to remember the importance of strict risk avoidance in investing. Marks' note concludes by saying, "The bottom line is this: the fact that we don’t know where trouble will come from shouldn’t allow us to feel comfortable in times when prices are full. The higher prices are relative to intrinsic value, the more we should allow for the unknown."

As numerous studies and real-world examples have shown, the best way to reduce risk is to buy financially sound companies at low valuations, and always assume the worst. As volatility returns, it is essential to keep this in mind.

Disclosure: The author owns no share mentioned.

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