Howard Marks: Risk and Why Most Investors Get It Wrong

by Howard Marks, Oaktree Capital

In April I had good results with Dare to Be Great II, starting from the base established in an earlier memo (Dare to Be Great, September 2006) and adding new thoughts that had occurred to me in the intervening years. Also in 2006 I wrote Risk, my first memo devoted entirely to this key subject. My thinking continued to develop, causing me to dedicate three chapters to risk among the twenty in my book The Most Important Thing. This memo adds to what Iā€™ve previously written on the topic.

What Risk Really Means

In the 2006 memo and in the book, I argued against the purported identity between volatility and risk. Volatility is the academicā€™s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in the calculations and models of modern finance theory. In the book I called it ā€œmachinable,ā€ and there is no substitute for the purposes of the calculations.

However, while volatility is quantifiable and machinable ā€“ and can also be an indicator or symptom of riskiness and even a specific form of risk ā€“ I think it falls far short as ā€œtheā€ definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I donā€™t think most investors fear volatility. In fact, Iā€™ve never heard anyone say, ā€œThe prospective return isnā€™t high enough to warrant bearing all that volatility.ā€ What they fear is the possibility of permanent loss.

Permanent loss is very different from volatility or fluctuation. A downward fluctuation ā€“ which by definition is temporary ā€“ doesnā€™t present a big problem if the investor is able to hold on and come out the other side. A permanent loss ā€“ from which there wonā€™t be a rebound ā€“ can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing ā€“ whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but we never get a chance to undo a permanent loss.

Of course, the problem with defining risk as the possibility of permanent loss is that it lacks the very thing volatility offers: quantifiability. The probability of loss is no more measurable than the probability of rain. It can be modeled, and it can be estimated (and by experts pretty well), but it cannot be known.

In Dare to Be Great II, I described the time I spent advising a sovereign wealth fund about how to organize for the next thirty years. My presentation was built significantly around my conviction that risk canā€™t be quantified a priori. Another of their advisors, a professor from a business school north of New York, insisted it can. This is something I prefer not to debate, especially with people whoā€™re sure they have the answer but havenā€™t bet much money on it.

One of the things the professor was sure could be quantified was the maximum a portfolio could fall under adverse circumstances. But how can this be so if we donā€™t know how adverse circumstances can be or how they will influence returns? We might say ā€œthe market probably wonā€™t fall more than x% as long as things arenā€™t worse than y and z,ā€ but how can an absolute limit be specified? I wonder if the professor had anticipated that the S&P 500 could fall 57% in the global crisis.

While writing the original memo on risk in 2006, an important thought came to me for the first time. Forget about a priori; if you define risk as anything other than volatility, it canā€™t be measured even after the fact. If you buy something for $10 and sell it a year later for $20, was it risky or not? The novice would say the profit proves it was safe, while the academic would say it was clearly risky, since the only way to make 100% in a year is by taking a lot of risk. Iā€™d say it might have been a brilliant, safe investment that was sure to double or a risky dart throw that got lucky.

If you make an investment in 2012, youā€™ll know in 2014 whether you lost money (and how much), but you wonā€™t know whether it was a risky investment ā€“ that is, what the probability of loss was at the time you made it. To continue the analogy, it may rain tomorrow, or it may not, but nothing that happens tomorrow will tell you what the probability of rain was as of today. And the risk of rain is a very good analogue (although Iā€™m sure not perfect) for the risk of loss.

Read/Download the whole letter below:

Risk Revisited

Source: Oaktree Capital

Copyright Ā© Oaktree Capital

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