“Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.”
With those words, Howard Marks (Trades, Portfolio) led off chapter five of “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor.” He also called risk an “essential” element of investing, and to underline its importance gave the subject three full chapters:
- Understanding it (this chapter).
- Recognizing when it is high (chapter 6).
- Controlling it (chapter 7).
Understanding risk is the subject of this chapter, and Marks launched into it by explaining why risk is an essential element:
- Risk is a negative element, and most investors want to avoid or minimize it. Given this aversion to risk, investors must always assess how serious it is when they make any investment.
- Investment decisions should be based on risk as well as returns. He wrote, “Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks.” Is the return worth the risk?
- Return does not mean a lot when considered on its own, it only makes sense within the context of the risk taken to achieve it. Marks said that investors must have a feeling for “risk-adjusted returns.”
The idea of risk-adjusted returns has been illustrated with this simple chart, with returns measured on the vertical axis, risk on the horizontal axis and the “capital market line” rising at an angle:
Because the capital market line is sloping upward to the right, we see a positive relationship between risk and return. That is, returns increase as risk increases. Alternatively, we might say that as risk increases, investors demand higher returns.
Marks considers this graph deceptive because it leads investors to believe they will (almost surely) get higher returns if they take more risk. It does not reflect the uncertainty of returns nor the possibility of increasing loss as risk increases.
With that, Marks turned to defining risk. As he pointed out, synonyms for risk include danger, hazard, jeopardy and peril. Yet, when academics defined risk for finance theory, they used the concept of “volatility,” which refers to variability or deviation. It does not capture the sense of danger or peril.
He argued the academics had likely seized upon volatility because it could be measured, was objective and could be extrapolated forward. However, few investors think of actual volatility when they think of risk—they think of potential for the permanent loss of capital. And that’s not just theory, but “The possibility of permanent loss is the risk I worry about, Oaktree worries about and every practical investor I know worries about.” (Marks is a co-founder and manager of Oaktree Capital.)
He also listed other types of risk. For example:
- Failing to meet investment goals, especially important for retirees.
- Underperformance or “benchmark risk,” which matters a great deal to investment managers.
- Career risk, which Marks called an extreme form of underperformance risk.
- Unconventionality, again a concern for investment managers.
- Lack of liquidity will be a problem for investors who want to divert some of their investments into health care or a new house.
What gives rise to the risk of loss? For a start, it does not necessarily mean poor fundamentals in a stock; after all, that can be overcome if the price is suitably low. There is also “the combination of arrogance, failure to understand and allow for risk,” so one hiccup for the company or in the economy can spike the risk.
The main source, though, is psychology: Investors taking a position that is too positive and buying at prices that are too high. They see exciting stories about high returns, expect those returns to continue indefinitely and end up being burned.
While theory links high returns with high risk (see the chart above, again), “pragmatic” investors take the opposite position. They believe they can have both high returns and low risk by buying securities at a discount. From the opposite perspective, “overpaying implies both low return and high risk.”
With that, Marks made a case for unpopular stocks available at bargain prices. He wrote, “Much of the time, the greatest risk in these low-luster bargains lies in the possibility of underperforming in heated bull markets. That’s something the risk-conscious value investor is willing to live with.”
He then moved on to the issue of measuring risk. If we reject volatility as the true measure of risk, how can we measure the risk of loss, especially the permanent loss of capital? The short answer is that we cannot. We have no metric to quantify this form of risk, and so we depend on opinions, informed opinions if possible.
Informed investors have a couple of guidelines. One is their judgement on the “stability and dependability of value” and the other is the relationship between price and value. They also have the Sharpe ratio, which measures a portfolio’s excess return (its return above the rate on short-term Treasury bills) divided by the standard deviation of the return. Marks showed little enthusiasm for the ratio, but acknowledged it as the best tool available.
While most of us look at risk in the future, Marks also considered it in the past. Specifically, he was interested in knowing how much risk had been involved in concluded investments. Again, he found he couldn’t know in retrospect how much risk factored into investments that made or lost money. That’s because we cannot know what might have happened, but did not, in the past.
Nassim Nicholas Taleb wrote a book on the issue, about things that might have happened but did not: “Fooled by Randomness.” In it, he gave us the now popular notion of “black swan” events, extremely unlikely events that do occur and have a severe impact where and when they hit. It helps us understand that people can be right for the wrong reasons, and vice versa.
Among Marks’ concluding remarks were these, “Return alone—and especially return over short periods of time—says very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it.”
But since we cannot measure the risk of loss, we are left to opinions alone. And that takes Marks’ thinking full circle: “Risk can be judged only by sophisticated, experienced second-level thinkers.” The concept of second-level thinkers was introduced in the first chapter of this book.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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