Howard Marks is a world-renown investor, author, and billionaire. He currently is co-chairman at Oaktree Capital, which he co-founded. Marks is especially known for his memos. Warren Buffett himself said those memos are “the first thing I open and read” when they come in the mail.
Some of the greatest investors in the world love Howard Marks’s memos. This post is about the memo Risk Revisited Again from 2015. For the rest of this article, I will try to break down what Marks has written in a way that will hopefully be simple and easy to understand. We were also very lucky to have Howard on our podcast Finance Simplified: EP 2 — Simplifying Risk and Market Cycles with Howard Marks of Oaktree Capital.
Risk Revisited Again
This memo, written in June of 2015, is like a sequel to “Risk Revisited” from 2014. Marks starts this memo off with distinguishing between volatility and risk.
Volatility and Risk
Volatility is a way to measure risk. There are loads of calculations, such as beta, done on volatility because it’s a quantifiable risk. But not all risk is quantifiable. While volatility indicates riskiness, it isn’t the definition of risk. With risk, it’s important to understand what “investors worry about and thus demand compensation for bearing.”
Investors worry about losing money, not about the volatility they must bear. Volatility refers to the fluctuations in an investment’s value. Investors can withstand large amounts of price swings, i.e. high volatility, if they are convinced their investment will ultimately have positive returns. But, if the investor loses confidence in his investment during a decline, the investor may sell for a permanent loss when the decline was just temporary.
On the other hand, the investor may suffer a permanent loss if the investment has a decline that it doesn’t recover from ever again. As Marks puts it, investors “can ride out volatility” but they “never get a chance to undo a permanent loss.”
The risk that investors take is the risk of permanent loss in their investments. But, that risk, unlike volatility, is unquantifiable. The chances of permanent loss in an investment are cannot be known. That risk can be estimated or modeled, but never surely known.
Measuring Risk After the Fact
Marks emphasizes that risk can’t be measured after an investment rises or falls in value. How do you measure that risk of an investment that has doubled in a year after it has doubled? Some may say that it wasn’t risky because it turned a profit. Others may say that in order to double an investment a large amount of risk must have been taken. Marks isn’t sure how to measure that risk.
An investment that is looked at after it increases or decreases in value cannot tell you the probability of losing money the day the investment was made. Marks makes an analogy with rain to convey this principle: “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.”
Nothing that happens after your investment appreciates or depreciates tells you about the initial chances of losing money when you made the investment.
Marks switches to talk about people he met who were smarter than him at investing. One of these people was the late Peter Bernstein. He was the author of “Against the Gods: The Remarkable Story of Risk” as well as an economist. He wrote a piece titled “Can We Measure Risk with a Number?” in June 2007. It emphasized that uncertainty is what risk is all about and that no model can predict 100% of the future. It also emphasizes what Marks observed in 2007 with the self-reinforcing increases in the level of risk investors took, leading to a high-risk environment.
As another economist, Hyman Minsky puts it, “Each state nurtures forces that lead to its own destruction.” With the investing climate Bernstein experienced in 2007, the level of risk investors took kept increasing, exposing them to vulnerabilities that manifested themselves in the crisis.
You Can’t Know the Future
The ideas behind economics aren’t all 100% dependable. Therefore, knowing the future isn’t possible. Risk is, therefore, something that can’t be reliably quantified, but can be estimated.
Marks doesn’t know the future. In truth, no one can know exactly what the future looks like. Economist John Kenneth Galbraith said that there are two types of forecasters: “Those who don’t know – and those who don’t know they don’t know.”
In regard to financial markets, there are a few reasons why the future is unknowable. One is the sheer number of factors that influence events, and the difficulty of predicting those factors and taking them into account all at once.
Additionally, the future can be impacted by events that no one thinks about. There is too much randomness in the world for the future to be accurately predicted. More importantly, the “connections between contributing influences and future outcomes are far too imprecise and variable for the results to be dependable.”
In other words, the cause and predicted effect relationships in economics are too weak to be meaningful.
Economics Isn’t A Science
It’s important to understand that economics isn’t a science like physics or chemistry. A change in an input variable doesn’t always result in the predicted output. Economics, unlike other sciences, is influenced heavily by human behavior, which is always difficult to factor in. Economics can explain things based on assumptions about human behavior, such as the assumption that all humans will act rationally, which isn’t the case. But because of those assumptions, there is an element of risk that those assumptions are wrong. The relation between economic influences and their outcomes is uncertain, and that introduces risk. Because of those reasons — an immense amount of influential factors, randomness, and weak economic connections — Marks believes that “future events cannot be predicted with any consistency.”
Dealing with the Unpredictabe
But if the future is unknowable, how can investors position their investments for those future events? Just because something is unpredictable doesn’t mean it can’t be dealt with. The way to deal with it is to view the future as a probability distribution involving different events. In other words, view the future as a range of possible future outcomes and their chances of occurring. The estimation of risk, even by experienced experts, will be inherently subjective than objective. Marks prefers to have risk be approximated by an expert rather than it be a precise number because he knows that precision is nigh-impossible to achieve, and so the exact number is likely to be wrong.
According to Marks, people who have a superior understanding of the possible outcomes and their likelihoods are more likely to be superior investors. These investors look at the probability distribution presented to them and find asymmetries.
The uncertainty of the future is what creates risk. If everything that was going to happen was known, there would be no risk. The risk in investments in stocks comes from the chance that expectations about the performance of the company are not met. There are many expectations that investors have regarding the performance of a company, such as sales growth, costs, etc. There are many possible outcomes for these expectations. The outcome that will come to pass will meet, exceed, or disappoint investors’ expectations. The most likely outcome may not be the one that occurs. And, the possibility of outcomes that disappoint is where risk originates.
Marks quotes London Business School professor Elroy Dimson to summarize his point: “Risk means more things can happen than will happen.” And for investors, the chances that events that negatively impact their investments come to pass are the source of investing risk.
Knowing the probabilities of events isn’t enough because just knowing the chances of something happen doesn’t mean you know what will happen. A probability isn’t a certainty. It’s simply a predicted chance of an outcome. Only one event will inevitably occur, and at the point that it does, it’s not a probability anymore, but rather an outcome. Only one of the many things that could happen will eventually happen. And because only one thing will happen, investing is similar to the lottery as choosing an investment is like “pulling one ticket from a bowlful”. But, investors who have a better idea of what is in the bowl can judge whether or not buying a ticket is worth it, which is what makes those investors superior to others.
Risk and Return?
Risk and return are positively correlated: the more the risk, the greater the potential reward. But if riskier investments always led to higher returns, then they wouldn’t be risky in the first place. Just because something is risky doesn’t mean it will produce higher returns, as many investors have learned the hard way. By definition, a risky investment isn’t certain to deliver high returns.
Marks thinks that the relationship between risk and reward can be described in a better way: “Investments that seem riskier have to appear likely to deliver higher returns, or else people won’t make them.”
In other words, the risk an investment brings needs to appear to be worth it for investors in relation to the potential rewards. The appearance of being worthy of investment is subject to investors’ opinions about the future. The more risk taken corresponds to higher potential gains, but also higher potential losses.
In summary, riskier investments are ones where there is more uncertainty about its outcome and carries higher potential gains as well as higher potential losses.
Looking to History
Many investors turn to history to look for ways to manage risk. Risk only exists in the future because it’s impossible to know the future. Expectations are based often on past events, ad history is used to “justify our forecasts of the long run.”
While that seems reasonable, history shows that unexpected events are the norm, not the outlier. So, past events should always be taken with skepticism in their ability to forecast the future. The financial crisis was statistically considered as a low probability event, yet it came to pass. Something different happens once in a while, and often that event isn’t correctly estimated in its improbability of happening.
Most people usually expect the future to be similar to the past, and therefore underestimate the chances for change, good or bad, in the future. Another downside of basing the future off the past is with “worst-case” projections which are often not negative enough. The crisis was an example where the projected worst-case scenario was exceeded. Worst-case projections use the past as a reference for what “worse” means. But, the future is unpredictable and conditions can be very different than those from the past. The bottom line is that history isn’t always a reliable predictor of the future.
Marks points out that investment losses don’t follow an even distribution throughout time but rather occur in intervals. In other words, investors see more losses at certain points in time than others. Risk isn’t distributed evenly, so the losses from it shouldn’t be either. One thing that allows for greater chances of losing an investment is not understanding what the investment is. During times of great bullishness and optimism, people tend to put more faith in their ability to recognize risk and understand investments they’ve never actually seen in action. Without actually understanding what the investments are and the risks they entail, investors expose themselves to a higher chance of losing money.
Marks’ main point is this: risk management is key to investing successfully. Too much risk can lead to losses, and too little risk can lead to below-average returns, but it’s important to understand the risk involved with each investment. Otherwise, as seen with 2007, misjudgments of risks lead to failure.
Different Types of Risks
While Marks has expounded on the risk of permanent loss, he also notes that there are other kinds of risks as well.
Risk of Falling Short
One of them is the risk of falling short of return goals. There are two possible causes of falling short and getting inadequate returns. One is the failure of a potential high-return investment to actually return the high amount. The other is the success of a low-return investment. This presents two risks to investors: the risk of loss and the risk of missing opportunities. Investors must deal with one of these risks as both risks cannot be eliminated. The latter risk, that of potentially missing opportunities, can be considered as “the risk of not taking enough risk.” This risk relates to FOMO, or the fear of missing out. FOMO is present in every bubble as many investors want to profit off a skyrocketing investment.
Other risks are present in Oaktree’s business, which is distressed debt. One is credit risk, or the risk that a borrower will default on interest payments. US Treasuries are considered credit risk free as are high-grade corporate bonds. As with any investment, in order to potentially earn a greater return from credit investments, the risk taken needs to be greater. Those who take an incrementally higher credit risk must do so knowing that the incremental promised return will be adequate. Oaktree’s management of credit risk is based on two beliefs: the incremental returns received for bearing credit risk “will compensate generously for the risk entailed” and that credit risk can be managed and gauged.
Another type of risk is illiquidity risk. This is the risk of losing value from tying up money in an investment that cannot be easily sold. Most investors favor liquidity as they can easily sell their investment when the time comes. Because more investors favor it, Marks believes that accessing superior returns can happen through illiquidity. That goes back to Marks’ contrarian thinking of finding opportunities in investments that the rest of the market stays away from.
Concentration risk is the risk of losing too much or gaining too little that comes from diversification. If there isn’t enough diversification, then mistakes in the portfolio will hit hard. If there’s too much diversification, then successes in the portfolio won’t have a large enough impact on overall returns.
Leverage and Funding Risk
The next type of risk Marks explains is leverage risk, which is the risk brought on by using leverage to enhance returns. Leverage can magnify gains, as a larger amount can be initially invested, but if the investment fails, the losses are magnified as well. Related to leverage risk is funding risk, or the risk that funding for an investment runs out before the investment is successful.
When taking on debt to make investments, if the return doesn’t pay out enough to cover the interest on the debt, then the investor must sell his investment, often at a depressed price, in order to pay off the debt. There may not be much left after the leverage is paid off. This means that the investor’s own money, or his equity, in his investment is essentially destroyed. If the investment that was sold to pay off debts turns out to be successful in the long-run, then the investor missed out on a huge opportunity.
When all those types of risks are intelligently managed, the investor has the ability to be successful in turning potential returns into realized returns.
Additionally, in an inefficient market, an investor can exceed or underperform average returns. Many people have investment managers who they hope will have better than average returns. That introduces manager risk, or the risk that the manager performs poorly compared to the market. It is crucial to know and understand the types and amounts of risk in each investment and to understand that in order to expect superior returns, bearing incremental risk is needed.
A volatile investment, if sold on a downward swing, will lead to a loss. It is hard to differentiate, in the short-term, between a downward swing and a permanent loss. If held through a downward swing that wasn’t a permanent loss, an investment will rebound and have positive returns. While volatility isn’t the definition of risk, it does represent it and is relevant to investing. Volatility connects to basis risk, which is the risk that the spread between a long position and a short position diverges to a larger than expected extent. The unexpected divergence is what led to Long-Term Capital Management’s meltdown in 1998.
Model and Black Swan Risk
Another risk that led to Long-Term’s failure was model risk. This is the risk of misusing or incorrectly choosing a model to base investment decisions on. Model risk can arise from black swan risk, which means that a model is limited and can’t predict black swan events, or extremely unexpected events. Models often use historical data, but up until the financial crisis, defaults to the level that they had been in 2007 had never happened before in history, so the model never factored in the chance of that event that never happened before happening. As Marks puts it, “The fact that a nationwide spate of mortgage defaults hadn’t happened convinced investors that it couldn’t happen, and their certainty caused them to take actions so imprudent that it had to happen.”
Fundamental and Valuation Risk
According to Marks, the two main ways an investment can be unsuccessful is through fundamental risk, which is related to how an investment truly performs, and valuation risk, which relates to how the market values that performance.
Valuation risk is easy to get rid of — just refuse to buy into an investment if its price is too high compared to its intrinsic value. The best way to reduce risk is by paying the lowest possible price, no matter how “irrationally low” it is. The more you pay for an asset, the riskier the investment is as the potential loss is greater.
These two risks refer to risk involved with a single investment, such as a stock. Correlation is another key component, as it is “the degree to which an asset’s price will move in sympathy with the movements of others.” The higher the correlation of an asset to its peers, the less of an effect diversification has, and the higher the loss can be if negative outcomes occur. But, every asset has different correlations with other assets. When managing a portfolio and diversifying, it is hard to predict the correlation of the investments, and therefore the effect of adding or removing investments from the portfolio is extremely difficult to predict.
Interest rate risk, or the risk that changes in interest rates have on other investments, affects investors, especially those in fixed income. If interest rates increase, then bonds become more attractive to investors due to an increased yield, which leads to lower stock valuations as the bonds are competing with stocks. Interest rate risk ties into purchasing power risk, or the risk that inflation diminishes the purchasing power of money. In order to prevent inflation from lowering the value of their money, investors push for higher interest rates and potential returns, which leads to lower prices as higher interest rates tend to lower stock and bond prices. Marks also talks about upside risk, or the risk of being underexposed to gains resulting from positive outcomes.
Big Picture of Risk
In looking at the big picture of risk, Marks makes several general statements.
Risk is Counterintuitive
The first is that “risk is counterintuitive.”
In other words, risk in investments often acts opposite to how the rest of the market perceives that risk. For example, as an asset’s price decreases, most people begin to think it’s riskier, which actually makes it less risky. Similarly, as an asset’s price increases, most people begin to think it’s safer, which actually makes it riskier. In regards to diversification, in trying to be safe, investors will under-diversify by only buying “safe” assets. But, counterintuitively, that makes them more exposed to a single shock. Adding some “risky” assets to a “safe” portfolio can actually make it safer as there is more diversification.
Risk Aversion Keeps Sanity and Safety
The second statement Marks makes is that “risk aversion is the thing that keeps markets safe and sane.”
When investors are more risk-averse, they demand more compensation for every extra bit of risk they take. So, the market should reward the investors for that risk-bearing. But when investors are risk-seeking, they demand less compensation for bearing risk and will make a risky investment with disproportionate returns, and risk-taking will eventually be punished. As Marks simply puts it, “risk is low when risk aversion and risk consciousness are high, and high when they’re low.”
Risk is Hidden and Deceptive
The third statement Marks makes is that “risk is often hidden and thus deceptive.”
Essentially, the level of risk in an investment manifests itself only after a negative event occurs and losses are incurred.
Risk is Multi-faceted
The fourth statement is that “risk is multi-faceted and hard to deal with.”
In this memo, Marks mentions 24 different types of risks and that they are all hard to manage successfully. Not much of an explanation needed there.
Risk Managers Shouldn’t Manage Risk
The fifth statement is that “the task of managing risk shouldn’t be left to designated risk managers.”
This fits with the idea that risk can’t be measured precisely, but rather, at best, approximated. For Marks, risk management should be something every investor must use their experience and knowledge to do.
Risk Should Be Constantly Dealt With
The sixth statement is that “while risk should be dealt with constantly, investors are often tempted to do so only sporadically.”
This is a reason why losses are lumped and not evenly distributed, as mentioned earlier, because risk only becomes loss when negative events occur and that causes investors who want to control risk to sell their positions at a loss. Risk control is not needed when losses don’t occur, but investors should still have it. Risk control can be compared to insurance because having it is important, even if the events the insurance helps with don’t come to pass.
Investing is Not Easy
Marks agrees with Charlie Munger’s view that anyone who thinks investing is easy is stupid. Continuing on that idea, Marks thinks that one of the greatest investing traps is thinking that controlling risk is easy. Too much confidence in the belief that their risk is properly being managed can lead investors to make very risky decisions. As a result, Marks believes that “the key prerequisites for risk control” are “humility, lack of hubris, and knowing what you don’t know.”
Marks points out that risk control is crucial, but that risk avoidance isn’t realistic. Risk avoidance “usually goes hand-in-hand with return avoidance.”
In trying to avoid the risk of losing money, you surrender the chance of making money. Without taking on risk, an investor shouldn’t expect to get a return.
Marks ends the memo with his view on the current market in June of 2015. At that time, he observed at ultra-low interest rates drove investors towards riskier investments in hopes of higher returns. As investors engage in riskier investments, they use less and less caution and become more and more aggressive. That has led to a decline in market standards because of the higher level of risk being taken. This sounds familiar, as risky behavior and loosening standards helped set up the crisis. And, though investors’ risk tolerance wasn’t as high as it was pre-crisis, it is in a “zone of imprudence.”
Marks believes that the conditions in 2015 warranted more attention to loss prevention than the potential for gains. He also says that while the economy and asset prices weren’t in bubble territory, the increase in risky behavior and low level of risk aversion were “creating a degree of risk for which there is no commensurate risk premium.”
In other words, he believed that the conditions were encouraging a higher level of risk that couldn’t be sustained.
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