“Great investing requires both generating returns and controlling risk. And recognizing risk is an absolute prerequisite for controlling it.”
Howard Marks (Trades, Portfolio) puts risk at the center of his investing strategy, so not surprisingly he devoted three chapters to it in his book, “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor.”
In the second of the three chapters, he began by re-emphasizing that risk refers to uncertainty about outcomes and the potential of loss, even permanent loss, as he pointed out in the previous chapter. That’s in contrast to the majority of investors, who believe risk refers to volatility, which is relatively routine price fluctuations.
Further, he attributes risk to paying too much for an asset such as a stock. Paying too much can apply to individual stocks or it can apply to the whole market—participating in overvalued stocks or markets, then, is the main source of risk. He also noted, “Whereas the theorist thinks return and risk are two separate things, albeit correlated, the value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices.”
Marks went on to tie this form of risk to the relationship between price and value, again to single stocks or whole markets. Being aware of this relationship is an “essential” part of successfully managing risk. In long-lasting bull markets, this relationship is distorted because investors believe everything will continue to go well and, consequently, take too much risk while stretching for ever-higher returns.
This includes buying stocks with high price-earnings ratios and private companies with high earnings before interest, taxes, depreciation and amortization multiples. As Marks observed, tongue-in-cheek, “Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we’ll continue to be alert for times when they don’t.”
In bullish times, investors tend to believe risk is disappearing or reduced, and thus drive up prices by buying more while ignoring the risk that really did not disappear. Marks reminded us this happened in the housing market between 2005 and 2007, when prices rose to bubble levels. He wrote, “This is one of the most dangerous of all processes, and its tendency to recur is remarkable.”
It is important to realize the level of risk in a market is set by the psychology of investors, not by the qualities of stocks or other securities. In 2007, Marks wrote, “Risk cannot be eliminated; it just gets transferred and spread. And developments that make the world look less risky usually are illusory, and thus in presenting a rosy picture they tend to make the world more risky. These are among the important lessons of 2007.”
And, from where do these investor feelings come from?
- Expecting very low returns on safer investments.
- Overperformance by risky securities in the recent past.
- Lots of capital flowing into the markets.
- Easy availability of credit.
On the other hand, value investors should go through a thought process that includes a series of comparisons, such as:
- We expect higher returns from five-year bonds than 30-day Treasury bills because of time risk.
- 10-year bonds should return even more than five-year bonds.
- Corporate debt should have a higher return than government debt.
With sets of assumptions like these, we have what’s known as the “yield curve”. As perceived risk increases, investors should demand higher returns, as shown along the capital market line (the line that slopes upward and to the right; the vertical line shows returns and the horizonal line shows risk):
From his 2013 perspective (when the book was published), Marks noted the capital market line had been forced down because of historically low interest rates. That meant:
- Investors scrambling away from “low-risk, low-return” investments.
- Risky investments became more attractive to investors, or as the author put it, they are “less repelled” by risky investments.
- Investors believe there is limited risk in the markets.
Because of the market situation that derives from low interest rates, many undisciplined investors have forsaken the yield curve and complacently put their money at risk.
He calls this a “richening” process, one that results in high price-earnings ratios, narrow credit spreads, undisciplined investing, lots of leverage plus demand for all kinds of investment vehicles. That, in turn, leads to higher prices and a higher-risk environment.
What’s needed is what Marks has called “second-level thinking,”Â which requires heightened awareness and disciplined action. As he noted, people in general overestimate their risk recognition skills and underestimate what is necessary to avoid risk. As a result, they unknowingly take on risk and “contribute to its creation.”
Collectively, investors push up the prices of assets. This leads to false confidence, making them bolder and less likely to insist on proper risk premiums. He added, “The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.”
This means the market is not static; it is dynamic because its various participants shape the future by their own actions. Then, there is the “perversity of risk,” which Marks defined as “Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk.”
Finally, Marks discussed the paradox of risk:
- When enough investors believe a security is risky, their decisions not to buy pushes the price down to the point where it is not risky at all.
- When enough investors believe there is no risk, they will bid up the price of a stock to the point where it becomes extremely risky.
In chapter six, Marks added to his earlier definition of risk; previously, he referred to it as the potential loss of capital, especially permanent capital. Now he has added a source to that definition, arguing it arises out of the failure of many investors to demand returns commensurate with their price-related risk. Therein lies the paradox of risk, that investors can increase their own risk, or reduce it, by paying too much or too little.
(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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