by Howard Marks
The reality of risk is much less simple and straightforward than the perception. People vastly overestimate their ability to recognize risk and underestimate what it takes to avoid it; thus, they accept risk unknowingly and in so doing contribute to its creation. That’s why it’s essential to apply uncommon, second-level thinking to the subject.
Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as their psychology strengthens and they become bolder and less worried, investors cease to demand adequate risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.
Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the “perversity of risk.”
JOEL GREENBLATT: A wonderful phrase to keep in mind when working up the courage to buy bargains after severe market drops.
HOWARD MARKS: The riskiest things: I’m very happy with the phrase “the perversity of risk.” When investors feel risk is high, their actions serve to reduce risk. But when investors believe risk is low, they create dangerous conditions. The market is dynamic rather than static, and it behaves in ways that are counterintuitive.
“I wouldn’t buy that at any price—everyone knows it’s too risky.” That’s something I’ve heard a lot in my life, and it has given rise to the best investment opportunities I’ve participated in. …
The truth is, the herd is wrong about risk at least as often as it is about return. A broad consensus that something’s too hot to handle is almost always wrong. Usually it’s the opposite that’s true.
I’m firmly convinced that investment risk resides most where it is least perceived, and vice versa:
• When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.
• And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. No risk is feared, and thus no reward for risk bearing—no “risk premium”—is demanded or provided. That can make the thing that’s most esteemed the riskiest.
This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky.
JOEL GREENBLATT: This thought process is pervasive among individual investors. For many, it is the fundamental flaw in their investment process.
But high quality assets can be risky, and low quality assets can be safe.
CHRISTOPHER DAVIS: I agree—there are a number of dangers that come from using a term like “quality.” First, investors tend to equate “high-quality asset” with “high-quality investment.” As a result, there’s an incorrect presumption or implication of less risk when taking on “quality” assets. As Marks rightly points out, quite often “high-quality” companies sell for high prices, making them poor investments. Second, “high quality” tends to be a phrase that incorporates a lot of hindsight bias or “halo effect.” Usually, people referring to a “high-quality” company are describing a company that has performed very well in the past. The future is often quite different. There is a long list of companies that were once described as “high quality” or “built to last” that are no longer around! For this reason, investors should avoid using the word “quality.”
It’s just a matter of the price paid for them. … Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.
“EVERYONE KNOWS,” APRIL 26, 2007
7
The Most Important Thing Is … Controlling Risk
When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.
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.
CHRISTOPHER DAVIS: For instance, lottery winners—though no one thinks they are investment geniuses.
Since it’s hard to gauge risk and risk-adjusted performance (even after the fact), and since the importance of managing risk is widely underappreciated, investors rarely gain recognition for having done a great job in this regard. That’s especially true in good times.
But in my opinion, great investors are those who take risks that are less than commensurate with the returns they earn. They may produce moderate returns with low risk, or high returns with moderate risk. But achieving high returns with high risk means very little—unless you can do it for many years, in which case that perceived “high risk” either wasn’t really high or was exceptionally well managed.
Consider the investors who are recognized for doing a great job, people such as Warren Buffett, Peter Lynch, Bill Miller and Julian Robertson. In general their records are remarkable because of their decades of consistency and absence of disasters, not just their high returns. Each may have had a bad year or two, but in general they dealt as well with risk as with return.
Whatever few awards are presented for risk control, they’re never given out in good times. The reason is that risk is covert, invisible. Risk—the possibility of loss—is not observable. What is observable is loss, and loss generally happens only when risk collides with negative events.
This is a very important point, so let me give you a couple of analogies to make sure it’s clear. Germs cause illness, but germs themselves are not illness. We might say illness is what results when germs take hold. Homes in California may or may not have construction flaws that would make them collapse during earthquakes. We find out only when earthquakes occur.
Likewise, loss is what happens when risk meets adversity. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when negative events occur in the environment.
We must remember that when the environment is salutary, that is only one of the environments that could have materialized that day (or that year). (This is Nassim Nicholas Taleb’s idea of alternative histories, described in more detail in chapter 16.) The fact that the environment wasn’t negative does not mean that it couldn’t have been. Thus, the fact that the environment wasn’t negative doesn’t mean risk control wasn’t desirable, even though—as things turned out—it wasn’t needed at that time.
The important thing here is the realization that risk may have been present even though loss didn’t occur. Therefore, the absence of loss does not necessarily mean the portfolio was safely constructed. So, risk control can be present in good times, but it isn’t observable because it’s not tested. Ergo, there are no awards. Only a skilled and sophisticated observer can look at a portfolio in good times and divine whether it is a low-risk portfolio or a high-risk portfolio.
In order for a portfolio to make it through tough times, the risk generally has to be well controlled. If the portfolio thrives in good times, however, we can’t tell whether risk control was (a) present but not required or (b) lacking. Bottom line: risk control is invisible in good times but still essential, since good times can so easily turn into bad times.
What’s the definition of a job well done?
Most observers think the advantage of inefficient markets lies in the fact that a manager can take the same risk as a benchmark, for example, and earn a superior rate of return. Figure 7.1 p
resents this idea and depicts the manager’s “alpha,” or value added through skill.
Figure 7.1
This manager has done a good job, but I think this is only half the story—and for me the uninteresting half. An inefficient market can also allow a skilled investor to achieve the same return as the benchmark while taking less risk, and I think this is a great accomplishment (figure 7.2).
Figure 7.2
Here the manager’s value added comes not through higher return at a given risk, but through reduced risk at a given return. This, too, is a good job—maybe even a better one.
Some of this is semantic and depends on how you look at the graphs. But because I think fundamental risk reduction can provide the foundation for an extremely successful investing experience, this concept should receive more attention than it does. How do you enjoy the full gain in up markets while simultaneously being positioned to achieve superior performance in down markets? By capturing the up-market gain while bearing below-market risk … no mean feat.
“RETURNS, ABSOLUTE RETURNS AND RISK,” JUNE 13, 2006
JOEL GREENBLATT: Finding such a talent will usually involve assessing the investment process of a manager rather than analyzing returns relative to a benchmark.
Now we come back to the germs that haven’t taken hold, or perhaps the earthquakes that haven’t happened. A good builder is able to avoid construction flaws, while a poor builder incorporates construction flaws. When there are no earthquakes, you can’t tell the difference.
Likewise, an excellent investor may be one who—rather than reporting higher returns than others—achieves the same return but does so with less risk (or even achieves a slightly lower return with far less risk). Of course, when markets are stable or rising, we don’t get to find out how much risk a portfolio entailed. That’s what’s behind Warren Buffett’s observation that other than when the tide goes out, we can’t tell which swimmers are clothed and which are naked.
It’s an outstanding accomplishment to achieve the same return as the risk bearers and do so with less risk. But most of the time it’s a subtle, hidden accomplishment that can be appreciated only through sophisticated judgments.
Since usually there are more good years in the markets than bad years, and since it takes bad years for the value of risk control to become evident in reduced losses, the cost of risk control—in the form of return forgone—can seem excessive. In good years in the market, risk-conscious investors must content themselves with the knowledge that they benefited from its presence in the portfolio, even though it wasn’t needed. They’re like the prudent homeowners who carry insurance and feel good about having protection in place … even when there’s no fire.
Controlling the risk in your portfolio is a very important and worthwhile pursuit. The fruits, however, come only in the form of losses that don’t happen. Such what-if calculations are difficult in placid times.
PAUL JOHNSON: This is the ultimate paradox of risk management.
Bearing risk unknowingly can be a huge mistake, but it’s what those who buy the securities that are all the rage and most highly esteemed at a particular point in time—to which “nothing bad can possibly happen”—repeatedly do. On the other hand, the intelligent acceptance of recognized risk for profit underlies some of the wisest, most profitable investments—even though (or perhaps due to the fact that) most investors dismiss them as dangerous speculations.
When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.
What does it mean to intelligently bear risk for profit? Let’s take the example of life insurance. How can life insurance companies—some of the most conservative companies in America—insure people’s lives when they know they’re all going to die?
• It’s risk they’re aware of. They know everyone’s going to die. Thus they factor this reality into their approach.
• It’s risk they can analyze. That’s why they have doctors assess applicants’ health.
• It’s risk they can diversify. By ensuring a mix of policyholders by age, gender, occupation and location, they make sure they’re not exposed to freak occurrences and widespread losses.
• And it’s risk they can be sure they’re well paid to bear. They set premiums so they’ll make a profit if the policyholders die according to the actuarial tables on average. And if the insurance market is inefficient—for example, if the company can sell a policy to someone likely to die at age eighty at a premium that assumes he’ll die at seventy—they’ll be better protected against risk and positioned for exceptional profits if things go as expected.
We do exactly the same things in high yield bonds, and in the rest of Oaktree’s strategies. We try to be aware of the risks, which is essential given how much our work involves assets that some simplistically call “risky.” We employ highly skilled professionals capable of analyzing investments and assessing risk. We diversify our portfolios appropriately. And we invest only when we’re convinced the likely return far more than compensates for the risk.
I’ve said for years that risky assets can make for good investments if they’re cheap enough. The essential element is knowing when that’s the case. That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.
“RISK,” JANUARY 19, 2006
While risk control is essential, risk bearing is neither wise nor unwise per se. It’s inevitably part of most investment strategies and investment niches. It can be done well or poorly, and at the right time or the wrong time. If you have enough skill to be able to move into the more aggressive niches with risk under control, it’s the best thing possible. But the potential pitfalls are many, and they must be avoided.
Careful risk controllers know they don’t know the future. They know it can include some negative outcomes, but not how bad they might be, or exactly what their probabilities are. Thus, the principal pitfalls come in the inability to know “how bad is bad,” and in resulting poor decisions.
Extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it’ll never happen—that assumptions regarding risk were too conservative. Thus, it becomes tempting to relax rules and increase leverage. And often this is done just before the risk finally rears its head. As Nassim Nicholas Taleb wrote in Fooled by Randomness:
Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security. … Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. … One is thus capable of unwittingly playing Russian roulette—and calling it by some alternative “low risk” name.
The financial institutions played a high-risk game in 2004–2007 thinking it was a low-risk game, all because their assumptions on losses and volatility were too low. We’d be watching an entirely different picture if only they’d said, “This stuff is potentially risky. Since home prices have gone up so much and mortgages have been available so easily, there just might be widespread declines in home prices this time. So we’re only going to lever up half as much as past performance might suggest.”
It’s easy to say they should have made more conservative assumptions. But how conservative?
PAUL JOHNSON: This is the key question when it comes to assessing risk.
You can’t run a business on the basis of worst-case assumptions. You wouldn’t be able to do anything. And anyway, a “worst-case assumption” is really a misnomer; there’s no such thing, short of a total loss. Now, we know the quants shouldn’t have assumed there couldn’t be a nationwide decline in home prices. But once you gra
nt that such a decline can happen—for the first time—what extent should you prepare for? Two percent? Ten? Fifty?
The [2008] headlines are full of entities that have seen massive losses, and perhaps meltdowns, because they bought assets using leverage. … These investors put on leverage that might have been appropriate with moderate-volatility assets and ran into the greatest volatility ever seen. It’s easy to say they made a mistake. But is it reasonable to expect them to have girded for unique events?
If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year [2008], it’s possible no leverage would ever be used. Is that a reasonable reaction? (In fact, it’s possible that no one would ever invest in these asset classes, even on an unlevered basis.)
In all aspects of our lives, we base our decisions on what we think probably will happen. And, in turn, we base that to a great extent on what usually happened in the past. We expect results to be close to the norm (A) most of the time, but we know it’s not unusual to see outcomes that are better (B) or worse (C). Although we should bear in mind that, once in a while, a result will be outside the usual range (D), we tend to forget about the potential for outliers. And importantly, as illustrated by recent events, we rarely consider outcomes that have happened only once a century … or never (E) (figure 7.3).
Figure 7.3
Even if we realize that unusual, unlikely things can happen, in order to act we make reasoned decisions and knowingly accept that risk when well paid to do so. Once in a while, a “black swan” will materialize. But if in the future we always said, “We can’t do such-and-such, because the outcome could be worse than we’ve ever seen before,” we’d be frozen in inaction.
