The Most Important Thing Illuminated

by Howard Marks

  5

  The Most Important Thing Is … Understanding Risk

  Risk means more things can happen than will happen.

  ELROY DIMSON

  Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable. Thus, dealing with risk is an essential—I think the essential—element in investing. It’s not hard to find investments that might go up. If you can find enough of these, you’ll have moved in the right direction. But you’re unlikely to succeed for long if you haven’t dealt explicitly with risk. The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it. Because the issue is so complex and so important, I devote three chapters to examining risk in depth.

  PAUL JOHNSON: Marks’s discussion of risk in chapters 5, 6, and 7 is the most comprehensive and complete I have ever seen in an investment book. Furthermore, his is the best articulation of risk I have encountered in any discussion or publication. These three chapters are the highlight of the book for me.

  Why do I say risk assessment is such an essential element in the investment process? There are three powerful reasons.

  First, risk is a bad thing, and most level-headed people want to avoid or minimize it. It is an underlying assumption in financial theory that people are naturally risk-averse, meaning they’d rather take less risk than more. Thus, for starters, an investor considering a given investment has to make judgments about how risky it is and whether he or she can live with the absolute quantum of risk.

  Second, when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks. Put simply, if both a U.S. Treasury note and small company stock appeared likely to return 7 percent per year, everyone would rush to buy the former (driving up its price and reducing its prospective return) and dump the latter (driving down its price and thus increasing its return). This process of adjusting relative prices, which economists call equilibration, is supposed to render prospective returns proportional to risk.

  So, going beyond determining whether he or she can bear the absolute amount of risk that is attendant, the investor’s second job is to determine whether the return on a given investment justifies taking the risk. Clearly, return tells just half of the story, and risk assessment is required.

  Third, when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well. Was the return achieved in safe instruments or risky ones? In fixed income securities or stocks? In large, established companies or smaller, shakier ones? In liquid stocks and bonds or illiquid private placements? With help from leverage or without it? In a concentrated portfolio or a diversified one?

  Surely investors who get their statements and find that their accounts made 10 percent for the year don’t know whether their money managers did a good job or a bad one. In order to reach a conclusion, they have to have some idea about how much risk their managers took. In other words, they have to have a feeling for “risk-adjusted return.”

  JOEL GREENBLATT: However, many individual and institutional investor decisions are based on this number, which has little explanatory or predictive value.

  Figure 5.1

  It is from the relationship between risk and return that arises the graphic representation that has become ubiquitous in the investment world (figure 5.1). It shows a “capital market line” that slopes upward to the right, indicating the positive relationship between risk and return. Markets set themselves up so that riskier assets appear to offer higher returns. If that weren’t the case, who would buy them?

  The familiar graph of the risk-return relationship is elegant in its simplicity. Unfortunately, many have drawn from it an erroneous conclusion that gets them into trouble.

  Especially in good times, far too many people can be overheard saying, “Riskier investments provide higher returns. If you want to make more money, the answer is to take more risk.” But riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple: if riskier investments reliably produced higher returns, they wouldn’t be riskier!

  The correct formulation is that in order to attract capital, riskier investments have to offer the prospect of higher returns, or higher promised returns, or higher expected returns. But there’s absolutely nothing to say those higher prospective returns have to materialize.

  The way I conceptualize the capital market line makes it easier for me to relate to the relationship underlying it all (figure 5.2).

  Figure 5.2

  JOEL GREENBLATT: This graph is a helpful way to visualize risk vs. return. Another helpful way to think about the probability distribution of future returns is to remember that the outcome distribution of these possible returns is not, in reality, normally distributed.

  HOWARD MARKS: Investing requires us to deal with the future. If the future were knowable by all, investing wouldn’t be very challenging (or, consequently, very profitable). Because it’s not, my final key theme surrounds the importance of understanding uncertainty. The graphic above illustrates the essence of “riskier” investments. This isn’t an abstraction; riskier investments involve greater uncertainty regarding the outcome, as well as the increased likelihood of some painful ones.

  Riskier investments are those for which the outcome is less certain. That is, the probability distribution of returns is wider. When priced fairly, riskier investments should entail:

  • higher expected returns,

  • the possibility of lower returns, and

  • in some cases the possibility of losses.

  The traditional risk/return graph (figure 5.1) is deceptive because it communicates the positive connection between risk and return but fails to suggest the uncertainty involved. It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money.

  I hope my version of the graph is more helpful.

  PAUL JOHNSON: Marks’s discussion of the relationship between risk and return offers important clarity, particularly in this comparison of figures 5.1 and 5.2. The additional insight offered by figure 5.2 leads to a much clearer view of the proper way to relate risk and return than that presented in the more common figure 5.1.

  It’s meant to suggest both the positive relationship between risk and expected return and the fact that uncertainty about the return and the possibility of loss increase as risk increases.

  “RISK,” JANUARY 19, 2006

  PAUL JOHNSON: So well said! Marks’s dismissal of risk’s equaling volatility, favored by academics and some practitioners, is excellent. Instead, Marks offers a much more insightful definition of risk.

  JOEL GREENBLATT: Comparing the risk of permanent loss of capital to potential reward is one of the most important concepts in investing. Yet Marks points out that many academic versions of risk, which are merely the measure of volatility relative to returns, miss much of the point. They do not reflect most investors’ perception of risk.

  Our next major task is to define risk. What exactly does it involve? We can get an idea from its synonyms: danger, hazard, jeopardy, peril. They all sound like reasonable candidates, and pretty undesirable.

  And yet, finance theory (the same theory that contributed the risk-return graph shown in figure 5.1 and the concept of risk-adjustment) defines risk very precisely as volatility (or variability or deviation). None of these conveys the necessary sense of “peril.”

  According to the academicians who developed capital market theory, risk equals volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition of risk.

  It’s my view that—knowingly or unknowingly—academicians settled on volatility as the proxy for risk as a matter of convenience. They ne
eded a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risk do not. The problem with all of this, however, is that I just don’t think volatility is the risk most investors care about.

  There are many kinds of risk. … But volatility may be the least relevant of them all. Theory says investors demand more return from investments that are more volatile. But for the market to set the prices for investments such that more volatile investments will appear likely to produce higher returns, there have to be people demanding that relationship, and I haven’t met them yet. I’ve never heard anyone at Oaktree—or anywhere else, for that matter—say, “I won’t buy it, because its price might show big fluctuations,” or “I won’t buy it, because it might have a down quarter.” Thus, it’s hard for me to believe volatility is the risk investors factor in when setting prices and prospective returns.

  Rather than volatility, 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.” No, I’m sure “risk” is—first and foremost—the likelihood of losing money.

  “RISK,” JANUARY 19, 2006

  The possibility of permanent loss is the risk I worry about, Oaktree worries about and every practical investor I know worries about.

  PAUL JOHNSON: I would go so far as to say that the risk of permanent capital loss is the only risk to worry about.

  But there are many other kinds of risk, and you should be conscious of them, because they can either (a) affect you or (b) affect others and thus present you with opportunities for profit.

  Investment risk comes in many forms. Many risks matter to some investors but not to others, and they may make a given investment seem safe for some investors but risky for others.

  • Falling short of one’s goal—Investors have differing needs, and for each investor the failure to meet those needs poses a risk. A retired executive may need 4 percent per year to pay the bills, whereas 6 percent would represent a windfall. But for a pension fund that has to average 8 percent per year, a prolonged period returning 6 percent would entail serious risk. Obviously this risk is personal and subjective, as opposed to absolute and objective. A given investment may be risky in this regard for some people but riskless for others. Thus this cannot be the risk for which “the market” demands compensation in the form of higher prospective returns.

  • Underperformance—Let’s say an investment manager knows there won’t be more money forthcoming no matter how well a client’s account performs, but it’s clear the account will be lost if it fails to keep up with some index. That’s “benchmark risk,” and the manager can eliminate it by emulating the index. But every investor who’s unwilling to throw in the towel on outperformance, and who chooses to deviate from the index in its pursuit, will have periods of significant underperformance. In fact, since many of the best investors stick most strongly to their approach—and since no approach will work all the time—the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up. (See Warren Buffett and Julian Robertson in 1999. That year, underperformance was a badge of courage because it denoted a refusal to participate in the tech bubble.)

  JOEL GREENBLATT: In the decade of the 2000s, 79 percent of the investment managers who ended up in the top quartile of performance spent at least three years in the bottom quartile (source: Davis Advisors). Most investors chase the hot fund and don’t stick with managers who underperform over the short term.

  • Career risk—This is the extreme form of underperformance risk: the risk that arises when the people who manage money and the people whose money it is are different people. In those cases, the managers (or “agents”) may not care much about gains, in which they won’t share, but may be deathly afraid of losses that could cost them their jobs. The implication is clear: risk that could jeopardize return to an agent’s firing point is rarely worth taking.

  • Unconventionality—Along similar lines, there’s the risk of being different. Stewards of other people’s money can be more comfortable turning in average performance, regardless of where it stands in absolute terms, than with the possibility that unconventional actions will prove unsuccessful and get them fired. … Concern over this risk keeps many people from superior results, but it also creates opportunities in unorthodox investments for those who dare to be different.

  • Illiquidity—If an investor needs money with which to pay for surgery in three months or buy a home in a year, he or she may be unable to make an investment that can’t be counted on for liquidity that meets the schedule. Thus, for this investor, risk isn’t just losing money or volatility, or any of the above. It’s being unable when needed to turn an investment into cash at a reasonable price. This, too, is a personal risk.

  “RISK,” JANUARY 19, 2006

  Now I want to spend a little time on the subject of what gives rise to the risk of loss.

  First, risk of loss does not necessarily stem from weak fundamentals. A fundamentally weak asset—a less-than-stellar company’s stock, a speculative-grade bond or a building in the wrong part of town—can make for a very successful investment if bought at a low-enough price.

  Second, risk can be present even without weakness in the macroenvironment. The combination of arrogance, failure to understand and allow for risk, and a small adverse development can be enough to wreak havoc. It can happen to anyone who doesn’t spend the time and effort required to understand the processes underlying his or her portfolio.

  Mostly it comes down to psychology that’s too positive and thus prices that are too high. Investors tend to associate exciting stories and pizzazz with high potential returns. They also expect high returns from things that have been doing well lately. These souped-up investments may deliver on people’s expectations for a while, but they certainly entail high risk. Having been borne aloft on the crowd’s excitement and elevated to what I call the “pedestal of popularity,” they offer the possibility of continued high returns, but also of low or negative ones.

  HOWARD MARKS: The riskiest things: The most dangerous investment conditions generally stem from psychology that’s too positive. For this reason, fundamentals don’t have to deteriorate in order for losses to occur; a downgrading of investor opinion will suffice. High prices often collapse of their own weight.

  Theory says high return is associated with high risk because the former exists to compensate for the latter. But pragmatic value investors feel just the opposite: They believe high return and low risk can be achieved simultaneously by buying things for less than they’re worth. In the same way, overpaying implies both low return and high risk.

  Dull, ignored, possibly tarnished and beaten-down securities—often bargains exactly because they haven’t been performing well—are often the ones value investors favor for high returns. Their returns in bull markets are rarely at the top of the heap, but their performance is generally excellent on average, more consistent than that of “hot” stocks and characterized by low variability, low fundamental risk and smaller losses when markets do badly. Much of the time, the greatest risk in these low-luster bargains lies in the possibility of underperforming in heated bull markets. That’s something the risk-conscious value investor is willing to live with.

  I’m sure we agree that investors should and do demand higher prospective returns on the investments they perceive as riskier. And hopefully we can agree that losing money is the risk people care about most in demanding prospective returns and thus in setting prices for investments. An important question remains: how do they measure that risk?

  First, it clearly is nothing but a matter of opinion: hopefully an e
ducated, skillful estimate of the future, but still just an estimate.

  Second, the standard for quantification is nonexistent. With any given investment, some people will think the risk is high and others will think it’s low. Some will state it as the probability of not making money, and some as the probability of losing a given fraction of their money (and so forth). Some will think of it as the risk of losing money over one year, and some as the risk of losing money over the entire holding period. Clearly, even if all the investors involved met in a room and showed their cards, they’d never agree on a single number representing an investment’s riskiness. And even if they could, that number wouldn’t likely be capable of being compared against another number, set by another group of investors, for another investment. This is one of the reasons why I say risk and the risk/return decision aren’t “machinable,” or capable of being turned over to a computer.

  Ben Graham and David Dodd put it this way more than sixty years ago in the second edition of Security Analysis, the bible of value investors: “the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation.”

  Third, risk is deceptive. Conventional considerations are easy to factor in, like the likelihood that normally recurring events will recur. But freakish, once-in-a-lifetime events are hard to quantify. The fact that an investment is susceptible to a particularly serious risk that will occur infrequently if at all—what I call the improbable disaster—means it can seem safer than it really is.