What A Billionaire Can Teach Us About Risk

Howard Marks, the billionaire chairman of Oaktree, has a phenomenal track for creating wealth. He is also known for writing insightful commentary about markets and investing. His recent letter, “Risk Revisited”, stands out as an extraordinary missive on the nature of risk. When read together with his original letter, “Risk”, we can explore many topics related to risk and glean new insights.

In academic finance, risk is equivalent to volatility. The typical measure of risk is the standard deviation of returns, meaning how much an asset’s price fluctuates over a certain period of time. This measure is great from a statistical standpoint, as it makes it easy to quantify and calculate on this basis. However, it fails to capture the essence of risk or to consider all the different varieties of risk.

In his original piece on risk, Marks, starts out by completely rejecting this notion of risk, calling volatility risk as “the least relevant of them all”. Instead of being worried about the fluctuations in price of an asset, there are much more worthwhile things to worry about—like whether or not you are making money on your positions.

Instead, Marks proposes his own definition: “risk is — first and foremost– the likelihood of losing money”. For most people who are investing, this is absolutely critical, as they don’t want to lose money. They are willing to accept risk to make money, but long term, they certainly don’t want to lose money. Think about it: would you want to be in an investment that had volatile swings if it went up an average of 20% per year? Yes, and you would want to invest as much as possible. Would you want an investment that was not volatile but which lost a steady 5% per year? Obviously not. For most investors and traders, the main risk to worry about is the likelihood of losing money— and we don’t want to take too much risk and jeopardize our chances of making money.

In a previous blog post about risk, I proposed my own definition of risk: the likelihood of not meeting your goals. For most investors and traders whose goal is to make money, then risk means the probability of not meeting your goals. In this vein, Marks highlights a couple of kinds of risk that are very similar, e.g. underperformance or the risk of falling short. These are risks that arise when you can suffer adverse consequences even if you generate performance, because you didn’t generate enough performance. Various investors have different objectives or benchmarks, which mean that their objectives are different. For instance, a long-term pool of money like an endowment needs to generate more returns than inflation, otherwise it loses purchasing power; making 2% per year would mean positive returns but still falling short of their goal. Similarly, a 40 year old who is saving for a retirement account probably has an even higher return threshold, like 7% per year or more. For that person, making 4% per year would imperil their dream of a safe retirement, and is clearly not acceptable. Lastly, a mutual fund manager’s goal is to beat the benchmark index. If that benchmark is down 25% in a year and the fund manager is only down 15%, then he is a hero, even if he lost money. These three cases help us to realize why risk is more about not achieving your objectives, rather than losing money per se. However, for most of us, the chance of losing money represents the biggest worry for us.

What interests me are the various cateorgies of risk that Marks cites, especially because he considers them all to be more worrisome than volatility. I agree with him that volatility is perhaps the least of all of these, as the rest are much bigger obstacles to success for your average investor. Between his two pieces, he cites a litany of investment risks that are quite telling:

–Model risk, which is the risk that our financial or forecasting model is wrong. The spectacular meltdown of Long Term Capital Management, as detailed in When Genius Failed, serves as a cautionary tale for what happens when our models fail to work properly.

–Black swan risk, named in honor of Nassim Taleb’s book Black Swan. This refers to an event which is market moving and which upends our understanding of the world. The terrorist attacks of September 11th or the subprime meltdown are two perfect examples of large, unexpected dislocations in the markets that generated massive volatility.

— Illiquidity, when our investments can’t be turned readily into cash. This is a very real risk for most of us and most funds, as some assets like a real estate, a stake in an unlisted company or an illiquid stock can’t be liquidated to meet an emergency call for cash.

— Credit Risk, when we have to worry about the company’s ability to repay debt. If you lend money to a company via a loan or a bond, then you have to worry about the company’s credit quality. This can be a function of decisions made by the company’s management and also driven by the broader economy—obviously, in a bad downturn, many more companies will struggle to repay their debts. Nevertheless, this is a risk where you know in advance the risk premium that you are receiving for it, making it relatively straightforward to judge when you are taking too much or too little risk

— Concentration Risk, when you have a few eggs in one basket. If you are too concentrated, then one wrong step will hurt that much more, as it’s a much bigger part of your overall portfolio

–Leverage risk, whereby you are borrowing money to magnify your investment returns. This is a great idea if everything works, but again, if you get it wrong, then the leverage will severely impair your overall returns. There is also funding risk to worry about, which is when you either can’t roll over your financing or it would be much more expensive. If you can’t roll over your funding then you would have to sell assets immediately.

–Career risk, where if you underperform or perform too badly, then you lose your job. This obviously changes the risk/reward substantially for investing, because it makes the penalties or costs much bigger on the downside, especially if you lose money because of an offbeat investment that you make. Ceteris paribus, you would be even more reluctant to take risk.

–Unconventionality. Similar to career risk, because some people don’t like to stick out or look different, even if it may be the right decision purely on investment merits only. Marks cites the Keynes maxim, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally”. Instead, they try to avoid the idea of looking too different from the herd, thereby destining themselves to returns that are conventional.


The last two are more psychological risks—like career risk or unconventionality, whereby you are more worried about the ramifications, potential or real, of your investment decisions rather than the investment decisions themselves. These psychological risks I am less worried about and will not dwell on. If you generate returns and properly manage the investment risks, then you don’t have to worry about your career—no matter how unconventional you are!

Faced with all of these risks, it can seem investing is so fraught with peril that we shouldn’t even bother with investing. The key insight from Marks’ two pieces on risk that Oaktree is not in the business of avoiding risk; rather, it is in the business of accepting and managing recognized risks, understanding that it will be paid a risk premium in the long-term for having accepted these risks. The goal of an investor is to understand what risks they are taking, going in with their eyes open. If they are taking more risk, then in general they should be poised to make more money. Having made a judgment about the risks, they can then form their own conclusions about their likelihood of making money. While Marks is trying to find asymmetries that improve his odds of making money for the risks that he is taking, he can’t guarantee in advance that he will make money.

Furthermore, as he points out, while there will be a range of potential outcomes in advance, there will only be one actual outcome and it can’t altered after the fact. That’s why Marks compares risk to a weather forecast. We can guess about the chances for rain, much like estimating the likelihood of making or losing money, but it does not guarantee that we know the outcome in advance. Furthermore, once it has rained or not rained, then we are stuck with that outcome.

This is a brilliant comparison because things can go wrong or right, but we need to at least to make an educated guess about the probabilities involved and also need to make sure to mitigate the consequences if we are wrong. To further the example, if the probability of rain is sufficiently high, then we would want to take an umbrella with us, especially if we knew that we would catch a cold if we did get rained on.

The key point that I draw from this discussion is that investing is about evaluating the risks that you can and then making a decision as to how much and what kind of risks you want to accept. If you want to give yourself a decent chance of generating high performance, then you need to really embrace a lot of risk to have a chance of doing so. If you want to generate solid, disciplined returns, you can take the approach that Marks is taking now, whereby you select a few kinds of risks that you feel prepared and knowledgeable enough to take and invest accordingly. Ultimately, you can’t predict the future, but you must study risks and sensibly take them on in order to make money.

Related to Mark’s two letters, here is an interview with him and transcript:


By Bruce Bower | E-mail: Bruce [at] howoftrading.com

Blog: www.howoftrading.com | Twitter: @HowOfTrading







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