To The Moon

Howard Marks is the co-founder and co-chairman of Oaktree Capital. He is the author of "The Most Important Thing About Investing" and has been updating the Oaktree Capital website with a quarterly memo for decades. He has a fascinating thought process and a knack for explaining complex concepts in a way that others can understand.

Source: Oaktree Capital

In a 2022 Wharton lecture, Marks explained how he believes investors should consider risk when investing in order to build wealth over time.

Why is it important to understand risk?

According to Marks, the risk is the most important thing in investing because the goal is to "make money and control risk". Therefore, if you understand the risk of an investment, you can understand the risk/reward trade-off and ultimately understand whether you should invest.

The goal for investors should be to place bets with asymmetric risk profiles, Marks says. For example, a bet with a potential return of 300% but only a 20% downside would be good because the goal is to "make more money than you could lose.

Volatility is not the risk

Source: mymoneysage

Traditional finance tells us that volatility, or Beta, which is how much a stock rises or falls relative to its index, is a form of risk. However - rather controversially - Marks argues that it is not. He argues that volatility can be an indicator of the presence of risk, "but not risk itself."

He quotes Einstein, who said, "Not everything that matters can be counted, and not everything that can be counted matters."

Risks, according to Marks, are not quantifiable in advance. The future may be different from the past, so even the use of historical data has its limitations. Marks adds that "risk is unquantifiable even in hindsight." For example, if you buy a stock at $100 per share, is it at risk after you sell it at $200? In terms of the end result, it's hard to say how much risk you took. Is it a low-risk investment, or is it a high-risk investment where you just got lucky?

So, as Marks says, "you can't judge the quality of a decision purely by the outcome." An analogy he has used in the past is to imagine walking through a dynamite factory with a lit match. If you survive and make it to the other side, you win $1 million, but if not, you die. Let's say A gets to the other side safely and is hailed as a genius, but is it a good investment decision? From a risk/reward perspective, it's not a good investment decision." I'd rather be vaguely right than precisely wrong." Marks said.

What is risk?

If volatility is not risk, then what is risk? Marks defines risk as the probability of a permanent loss of capital. For example, the price of a stock can move downward temporarily, which is volatility, but not necessarily risk.

Other types of risk include opportunity cost and selling at the bottom. Opportunity cost is the risk of losing the potential return on a better investment. This is also known as the risk of missing out and can also be referred to as "the risk that you didn't take enough risk".

Bottom selling refers to the risk of being forced out at the bottom. The market moves cyclically around an upward sloping trend line. A bad enough decline will cause people to sell because they may have lost confidence, but an often overlooked factor is that when the economy is bad, investors may have to sell at the bottom to pay their bills.

We can model different possibilities (best case, worst case, average case) and the likelihood of that happening. For example, I have developed Monte Carlo simulations that show the distribution of outcomes. However, the risk from a "black swan" event is still possible. This is the "long tail risk," or the risk that "we don't know what we don't know now.

The future is a probability distribution

Marks believes that the future should be viewed as a probability distribution. This is true of investing and many things in life." All knowledge is about the past and all decisions are about the future."

The future should not be seen as a fixed outcome destined to be predicted, but as a "range of outcomes." He gave the example of Hillary Clinton, who has an 80 percent chance of winning the presidential election, according to polls. Donald Trump, however, won despite having only a 20 percent chance according to polls. So it's clear that even seemingly unlikely scenarios can happen, especially if the yardstick you use to measure potential outcomes ignores a key part of the system that determines the true outcome. In reality, most of our predictions are just as flawed as using Internet polls to try to predict the outcome of an election.

Marks says, "The impossible keeps happening, and the possible is forever absent." If there is a probability of a loss, then the loss will occur when a negative event occurs. For example, a flawed house appears to stand until an earthquake hits.

Risk is not a function of asset quality

Surprisingly, Marks argues that risk is not a function of asset quality. For example, a high quality company may be overpriced and therefore risky. An example of this is the "Pretty 50" stocks of the 1960s and 1970s. These companies were categorized as the 50 "best" and "fastest" growing companies. However, Marks noted that if you held them for five years, "you'd lose all your money." A Wall Street adage is that "no one has ever been fired for investing in IBM" because IBM has always been seen as a "safe" blue-chip stock. But the company's golden age is long gone.

Instead, "low-quality assets can be cheap enough to make it safe." An example of this would be deep value stocks or the "junk bonds" that Marks invests in.

Dealing with risk

Dealing with risk should not be a three-day process, but a drop in the bucket. You should not try to switch between "risk off" and "risk on" mode, but should replace it with ongoing assessment. An example is purchasing auto insurance. If you don't have an accident at the end of the year, you won't feel like your premiums were "wasted". It's the same with portfolio risk management." From time to time, things will be different from what we expect because of the risk. When it does, how do we respond?"

You can be prudent in taking risk if the risk is one of the following

• You are aware of the risk.

• The risk can be analyzed.

• The risk can be diversified.

• The return clearly outweighs the risk.

Risk is something to be managed and controlled, "not avoided". Outstanding investors are outstanding because they have a "superior" sense of the probability distribution that governs future events and whether the returns compensate for the risk lurking in the left-hand tail of the distribution. But most of the time, this "superior" sense has no place, and risk only occasionally turns into loss.

At the end of the article, let's talk about how do you manage and control risk?

Source: https://www.gurufocus.com/news/1865982/howard-marks-what-is-investing-risk