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Howard Marks on Volatility, Investment Risk and Outcomes

Many investors fail to realize that assuming higher risk doesn't always lead to higher returns

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John Kinsellagh
Oct 23, 2019
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During a September 2014 interview with Bloomberg TV’s Stephanie Ruhle,

Howard Marks (Trades, Portfolio) discussed how it is a mistake to equate investment risk with volatility. Marks cautioned Ruhle that while volatility is quantifiable and machinable… it falls far short as "the" definition of investment risk.” Marks suggested that “volatility” is the academic’s preferred measure for defining and quantifying risk.

Marks drew the distinction in response to a question by Ruhle that the risk-reward axiom, as it is understood by most of the investing public, can be reduced to the preposition that, “if you want to make more money, you must take more risk.” And, as Marks notes, far too many investors labor under the misconception that “higher risk means higher returns.”

Marks pointed out how this correlation is misleading and spurious.

“The main thing people don’t understand is that it’s wrong to say if you want to make more money, take more risk. This is what people say. Higher -- riskier – riskier investments have higher returns. So if you want to make more money, take more risk. It can’t be right, Stephanie.”

The guru continued to expose this fallacy, by elaborating on his view that far too many investors misunderstand the concept of risk and return within the overall investment universe:

“If riskier could be counted on to produce higher returns, they wouldn’t be riskier. It’s as simple as that. There’s got to be something wrong with that formation. What we should say is that investments that appear riskier have to appear to offer higher returns or nobody will make them. But that doesn’t mean it has to come true. And lots of things other – lots of things can happen other than what you hope will happen.”

Marks said he agrees with the thesis that investing in riskier investment vehicles increases the probabilities of higher returns, however, it also increases the risk of your losses. This is due to the fact that a higher risk quotient inexorably leads to a scenario where:

“The range of possible outcomes becomes wider. With T-bills there’s no uncertainty. With the five-year there’s a little uncertainty. With corporates there’s a bunch. With stocks there’s more. The more risk you take, the more uncertain the outcome is, and the worse the bad ones are.”

Marks characterized those investors who think they know what’s going to happen in a heightened risk investment environment as “professional prognosticators.” He somewhat sarcastically noted that the term is an oxymoron:

“It’s not what you don’t know that gets you into trouble. It’s what you know for certain that just ain’t true. If you think you know something and act in certitude and turn out to be wrong, that’s how you lose a lot of money. If you say I’m really not sure what’s going to happen, I’m going to hedge my bets and diversify my portfolio, you’re less likely to get into trouble.”

The guru also more fully discussed his concept of risk and probable outcomes in his 2014 memo to clients, where he noted that:

“…in order to achieve superior results, an investor must be able – with some regularity – to find asymmetries: instances when the upside potential exceeds the downside risk. That’s what successful investing is all about.”

But identifying instances where the downside risk is less than the upside potential doesn’t necessarily mean an investor’s bet will pay off. This is because, as Mark’s explains, assessing the probabilities correctly doesn’t lead to a preferred outcome; the two concepts are not congruent nor necessarily correlated:

“As my friend Bruce Newberg says, 'There’s a big difference between probability and outcome.' Unlikely things happen – and likely things fail to happen – all the time. Probabilities are likelihoods and very far from certainties.Or to simplify the concept, 'Even though many things can happen, only one will.'”

Mark’s memo contains some other useful insights, paramount of which the fact that risk is counterintuitive:

“The riskiest thing in the world is the widespread belief that there’s no risk.”

Marks then incorporates one of the fundamental principles of value investing within the concept of investment risk, that:

“As an asset declines in price, making people view it as riskier, it becomes less risky (all else being equal).”

The converse is also true: “As an asset appreciates, causing people to think more highly of it, it becomes riskier.”

Reviewing Marks discussion of risk in his 2014 memo to Oaktree Clients, one is reminded of

Seth Klarman (Trades, Portfolio)’s idea that seizing investment opportunities frequently entails contrarian thinking as well as adopting the tenets of counterintuitive thinking, which he discusses so ably.

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