In his book, "The Most Important Thing,"Â Howard Marks (Trades, Portfolio) explains why investors need to have a good feeling for what risk is. First and foremost, people want to minimize risk. It is a starting premise of investment theory that individuals want to take on as little risk as possible, that they are risk-averse:
“For starters, an investor considering a given investment has to make judgments about how risky it is and whether he or she can live with the absolute quantum of risk.”
The notion of risk is joined at the hip with that of uncertainty. The prospects of securities with high risk have a high degree of uncertainty, while those with low risk have low uncertainty. Moreover, in efficient market theory, risk and return are always set against each other:
“When you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks. Put simply, if both a U.S. Treasury note and small company stock appeared likely to return 7 percent per year, everyone would rush to buy the former (driving up its price and reducing its prospective return) and dump the latter (driving down its price and thus increasing its return)”.
However, as we know, markets are not always efficient. Some assets have lower returns than their risk would suggest - as in the case of overvalued securities - and some have higher returns than their risk would suggest - as is often the case with distressed debt. The primary job of the value investor is to identify situations like the latter, in which they can buy high returns with low risk.
Do not mistake leverage for genius
The idea that risk and return can diverge allows us to assess an investor’s process:
“When you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well. Was the return achieved in safe instruments or risky ones? In fixed income securities or stocks? In large, established companies or smaller, shakier ones? In liquid stocks and bonds or illiquid private placements? With help from leverage or without it? In a concentrated portfolio or a diversified one?”
In other words, was the investor able to achieve impressive returns while controlling their risk, or did they cut corners? Someone who makes 10% by investing in government bonds is a legitimate wizard (or a liar). Someone who makes 10% by investing in private equity is probably underperforming, and endangering their capital. Steve Eisman, one of the principal characters in Michael Lewis’s book, "The Big Short," is fond of saying that in the run-up to 2008, banks “mistook leverage for genius.” Make sure you do not make the same mistake.
Read more here:
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- Howard Marks on Fed PolicyÂ
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