Revisiting Risk With Howard Marks
Going back through the 3 separate chapters on Risk in The Most Important Thing to deepen my own understanding of the variable that, when controlled well, drives long term success.
Howard Marks is one of the best writers to come out of the financial industry.
His calm prose has always been something I return to when I seek to deepen an understadning of a concept. His book, The Most Important Thing Illuminated, includes 20 chapters on these “concepts”. All 20 being “The Most Important Thing”.
I make it a goal to reread the book once a year as a way to remind myself of the principles I need to beat into my head if I want to be a solid investor.
Over the past two years, I have taken a keen interest in his chapters on risk.
You could say I was primed for the information. During this time frame there has been a few mistakes that have caused me to comb over my process and work to improve it.
This work has translated into taking a more humble approach to my “conviction” and a deeper appreciation for risk and all it entails.
I went back through his chapters on the concept and thought I’d share the big points for two reasons:
It will only ingrain the lessons into myself further.
Serve a reminder for those who have read the book and an introduction for those who have not (Thought it should be a must-read for all investors).
I hope it’s helpful.
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“Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.” - Howard. Marks
As an investor, your success in the short term will be determined by the winners you pick but your long-term success will be determined by your ability to deal with risk.
Before we can learn to deal with it we must be able to:
Most level-headed individuals, especially investors, want to do their best to avoid it or minimize it. It can never be extinguished completely as it works in tandem with its better-known brother, returns.
You can’t have one without the other. This is why a deep understanding of the concept of risk is imperative for investment success.
If we were to ask the Academics for their definition of risk their response would land in the range of the word volatility. Howard takes great issue with this because it doesn’t represent the actual desires of the investor.
“I think people decline to make investments primarily because they're worried about a loss of capital or an unacceptably low return. To me, "I need more upside potential because I'm afraid I could lose money" makes an awful lot more sense than "I need more upside potential because I'm afraid the price may fluctuate."
For an investor, the only definition is the possibility of permanent capital loss.
How do we measure it?
The short answer: You can’t.
There is no mathematical formula. The hidden, subjective, and unquantifiable nature of risk is what makes it so elusive and thus, hard to deal with.
You might not be able to put a number on it but it can be judged.
“A skillful investor has the ability to get a sense of the amount of risk in a given situation by looking at two factors:
The stability and dependability of value
The relationship between price and value”
These won’t give an exact amount, but they will tell you if the water is hot or cold.
Keep in mind the difference between probability and outcomes.
As much as we would like to hope, we do not live in a world that fits under a “normal” bell curve of probability.
There will be people who unknowingly subject themselves to a real risk, have it never show up, and look like a genius. Nassim Taleb calls these people “Lucky Idiots”. The other side will also be true, you can take every measure to protect your portfolio from 99% of all “worst-case scenarios” but the 1% left over can happen.
Even though the investor was extremely cautious, they can still look like a loser.
“The key to understanding risk: It’s largely a matter of opinion. It’s hard to be definitive about risk even after the fact” - Howard Marks
Returns alone tell you little about the quality of the decision made. The other side must be given attention. It can not be measured, but it can be judged based on the probable outcomes at a given point in time.
There will be those who run through a dynamite factory with a match and survive. But this doesn’t mean you should do it again.
Now that we understand what risk is and what it isn’t. To get to the final step of controlling it, we first have to learn how to recognize it.
It’s our job to defend against permanent capital loss.
The largest amounts of this risk tend to show up where it is perceived to be the lowest by the masses. The problem is the crowd is as often wrong about risk as it is about return and we tend to:
Overestimate our ability to recognize when risk is at its greatest. (When everything is going great and we don’t want the party to end)
Underestimate what it takes to avoid it. (Leaving the party early and looking like a loser)
Thus we should do our best to work contrary to the crowd, stay away from environments that lend themselves to higher risk, and dive in head first when the opposite is true.
To give you an idea of what a risky environment looks like, here is an excerpt from Howard’s memo, It’s All Good, in July of 2007.
“Where do we stand today [mid-2007]?
In my opinion, there's little mystery. I see low levels of skepticism, fear and risk aversion. Most people are willing to undertake risky investments, often because the promised returns from traditional, safe investments seem so meager. This is true even though the lack of interest in safe investments and the acceptance of risky investments have rendered the slope of the risk/return line quite flat. Risk premiums are generally the skimpiest I've ever seen, but few people are responding by refusing to accept incremental risk….”
Another helpful guide is a checklist Howard prepared in another chapter that I have reproduced here:
Staying away from permanent capital loss means staying away from situations where everyone thinks there is no chance of it.
“Outstanding investors, in my opinion, are distinguished at least as much for their ability to control risk as they are for generating return.
High absolute return is much more recognizable and titillating than superior risk adjusted performance. That's why it's high-returning investors who get their pictures in the papers.” - Howard Marks
There are two ways to be an above-average investor 1) achieve returns that are higher than average or 2) achieve average returns but take less risk to do so.
Most shoot for the first but forget about the second.
Because risk control is one of the least sexy things an investor can do.
The fruits are losses that do not materialize and when you take prudent steps to control your risk it means you are likely to underperform in bull markets.
Nobody likes to be that guy.
But the greats are that guy.
The impressive thing about individuals like Buffett and Klarman is their long track record of success that comes with no huge blow-ups. Yes, they have had a bad year or two but they have been able to produce a tremendous amount of outperformance by staying away from disasters rather than working to shoot the lights out.
The alpha comes during downturns because they focus on risk control, not return optimization.
We should work to do the same.
Investing is bearing risk for profit. But to do so intelligently means to work hard to ensure the risk you bear is controlled. To do this we need to do 4 things well:
Be aware of the risk we are taking: What is going to lead me to a permanent capital loss?
Be able to analyze it: Can I analyze these variables that lead me down this potential path?
Diversify away from it: How can I size this position to make sure if I am wrong I’m not dead?
Be compensated for it: How much return am I going to demand to bear this risk?
Mastering these 4 is what separates the best from the best.
“Clearly, Oaktree doesn’t run from risk. We welcome it at the right time, in the right instances, and at the right price” - Howard Marks
This is the process for a successful investor. You can’t run away from risk completely but you can decide the time, instances, and price at which you are willing to bear it.
Each investment comes with two sides, the potential IRRs into the future and the risk to achieve those. Although one is much easier to calculate than the other, the latter will have a larger effect on your long-term outcome than the former.
The best way to string together a career of compounding is to partake in the simple act of first looking to avoid situations where the risk to return is backward.
High-risk situations are usually filled with over-optimism and high prices when compared to current fundamentals.
If it is loved by the crowd. Run.
“The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors' results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.”
The best investors look down, not up.
I hope this little piece reemphasizes the importance of risk and how intertwined it is in the investment world. If you have not taken the time to read Howard’s book, I strongly encourage you to do so. It’s required reading for any investor.
Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.
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