Howard Marks: Nothing's Riskier Than a Widespread Belief That There's No Risk

Fear of risk is the essential disciplining ingredient in financial markets

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Sep 01, 2019
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Why do financial meltdowns happen when they are least expected? Why do the bad times inevitable eventually turn bad? The answer lies in denial of risk. In a memo from 2009 entitled
"Touchstones," value investor Howard Marks (Trades, Portfolio) explained why believing that a market has no risk is the most risky situation of all.

Human nature

The memo was written while the rubble of the financial crisis was still very much warm and not everyone had a clear idea of what had happened. However, a few things were clear: the crisis had been caused by investors buying and trading instruments the risk profiles of which they did not understand, with too much leverage. In Marks’ words, they believed they were living in a low-risk world:

“In 2006 and early 2007, for instance, we heard a lot about the “wall of liquidity” that was coming toward us from China and the oil producing countries, a flow that could be counted on to provide capital and raise asset prices non-stop. Likewise, we were told (a) the Fed had tamed the business cycle through its adroit management, (b) securitization, tranching and disintermediation had reduced risk by putting it where it could best be handled, and (c) the “Greenspan put” could always be counted on to bail out investors who made mistakes. These and other things were said to have lowered the risk level worldwide”.

People will always choose to believe that something down the line will bail them out and that the good times will continue. It’s just not human nature to be pessimistic (and that’s a good thing, otherwise how would anything get done?) However, this trait does have the downside of making us underestimate both the likelihood and magnitude of future risk events. The only time when we overestimate risk is immediately after a disastrous event has occurred. In other words, after the horse has already bolted from the stable. Fear of risk is a disciplining factor for investors:

The essential ingredient

“Worry and its relatives, distrust, skepticism and risk aversion, are essential ingredients in a safe financial system. To paraphrase a saying about the usefulness of bankruptcy, fear of loss is to capitalism as fear of hell is to Catholicism. Worry keeps risky loans from being made, companies from taking on more debt than they can service, portfolios from becoming overly concentrated, and unproven schemes from turning into popular manias. When worry and risk aversion are present as they should be, investors will question, investigate and act prudently. Risky investments either won’t be undertaken or will be required to provide adequate compensation in terms of anticipated return”.

The fundamental logic behind risk/return is that riskier projects will generally (but not always!) offer higher returns. In an environment with low perceived risk, however, the risk premium dissipates. Too much money chasing too many deals eventually shifts every single market participant out along the risk curve, causing every one of us to take on more risk for lower returns. That is the kindling for a financial meltdown. All that is required after that is the spark.

Disclosure: The author owns no stocks mentioned.