Volatility is the academic's choice for defining and measuring risk; but Oaktree Capital's Howard Marks warns Bloomberg TV's Stephanie Ruhle that "while volatility is quantifiable and machinable... it falls far short as 'the' definition of investment risk." In fact, he berates, "I don't think most investors fear volatility. In fact, I've never heard anyone say, 'The prospective return isn't high enough to warrant bearing all that volatility.' What they fear is the possibility of permanent loss." With $91 billion under management, perhaps it's worth listening to (and reading) his perspective: "In brief, if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier. Misplaced reliance on the benefits of risk bearing has led investors to some very unpleasant surprises."
Bloomberg TV interview:
STEPHANIE RUHLE: Surely you've heard this line before. If you want to make more money investing, take more risk. Fine. Great even, if you understand what risk actually means. Howard Marks says most people don't, and he should know. He's the chairman of Oaktree Capital and one of the greatest investors in distressed debt. Howard, welcome back. Your newest letter is out. Tell us, what don't people understand?
HOWARD MARKS, CHAIRMAN, OAKTREE CAPITAL MANAGEMENT: The main thing people don't understand is that it's wrong to say if you want to make more money, take more risk. This is what people say. Higher -- riskier -- riskier investments have higher returns. So if you want to make more money, take more risk. It can't be right, Stephanie.
MARKS: Because if riskier could be counted on to produce higher returns, they wouldn’t be riskier. It's at simple as that. There's got to be something wrong with that formation. What we should say is that investments that appear riskier have to appear to offer higher returns or nobody will make them. But that doesn't mean it has to come true. And lots of things other -- lots of things can happen other than what you hope will happen.
ERIK SCHATZKER: Is it also true that investing in riskier instruments increases your chances of higher returns but also of higher losses?
MARKS: Exactly, exactly. That's -- that's the thing that people have to understand. Yes, when you take on more risk you expect a higher return, but you should also understand --
SCHATZKER: Hope for a higher return.
MARKS: You hope, yes, but you should also understand that the range of possible outcomes becomes wider. With T-bills there's no uncertainty. With the five-year there's a little uncertainty. With corporates there's a bunch. With stocks there's more. The more risk you take, the more uncertain the outcome is, and the worse the bad ones are.
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MARKS: You shouldn't think you know what's going to happen.
SCHATZKER: But so many people do.
MARKS: Well, but they're wrong.
SCHATZKER: They're professional prognosticators.
MARKS: Exactly. That's an oxymoron. Mark Twain said it ain't what you don't know that gets you into travel. It's what you know for certain that just ain't true.
RUHLE: One more time?
MARKS: It's not what you don't know that gets you into trouble. It's what you know for certain that just ain't true. If you think you know something and act in certitude and turn out to be wrong, that's how you lose a lot of money. If you say I'm really not sure what's going to happen, I'm going to hedge my bets and diversify my portfolio, you're less likely to get into trouble.
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MARKS: I think that every investor faces two risks. Now if I say to you, Erik, what are the two risks, you'd get an A if you say the main one is the risk of losing money. But if you want to get an A plus you have to say the second one, and that is the risk of missing opportunity.
RUHLE: Fear of missing out.
MARKS: Now -- now the problem is we have the risk of losing money and the risk of missing opportunity, and you can eliminate either one.
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From Marks' memo below:
Key point number one in this memo is that the future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.
In other words, in order to achieve superior results, an investor must be able – with some regularity – to find asymmetries: instances when the upside potential exceeds the downside risk. That’s what successful investing is all about.
That leads me to my second key point, as expressed by Elroy Dimson, a professor at the London Business School: “Risk means more things can happen than will happen.” This brief, pithy sentence contains a great deal of wisdom.
This uncertainty as to which of the possibilities will occur is the source of risk in investing.
Key point number three: Knowing the probabilities doesn’t mean you know what’s going to happen.
Bruce Newberg says, “There’s a big difference between probability and outcome.” Unlikely things happen – and likely things fail to happen – all the time. Probabilities are likelihoods and very far from certainties.
It’s true with dice, and it’s true in investing . . . and not a bad start toward conveying the essence of risk. Think again about the quote above from Elroy Dimson: “Risk means more things can happen than will happen.” I find it particularly helpful to invert Dimson’s observation for key point number four: Even though many things can happen, only one will.
In brief, if riskier investments could be counted on to produce higher returns, they wouldn’t be riskier. Misplaced reliance on the benefits of risk bearing has led investors to some very unpleasant surprises.
To move to the biggest of big pictures, I want to make a few over-arching comments about risk.
The first is that risk is counterintuitive.
The riskiest thing in the world is the widespread belief that there’s no risk.
Fear that the market is risky (and the prudent investor behavior that results) can render it quite safe.
As an asset declines in price, making people view it as riskier, it becomes less risky (all else being equal).
As an asset appreciates, causing people to think more highly of it, it becomes riskier.
Holding only “safe” assets of one type can render a portfolio under-diversified and make it vulnerable to a single shock.
Adding a few “risky” assets to a portfolio of safe assets can make it safer by increasing its diversification. Pointing this out was one of Professor William Sharpe’s great contributions.
The second is that risk aversion is the thing that keeps markets safe and sane.
When investors are risk-conscious, they will demand generous risk premiums to compensate them for bearing risk. Thus the risk/return line will have a steep slope (the unit increase in prospective return per unit increase in perceived risk will be large) and the market should reward risk-bearing as theory asserts.
But when people forget to be risk-conscious and fail to require compensation for bearing risk, they’ll make risky investments even if risk premiums are skimpy. The slope of the line will be gradual, and risk taking is likely to eventually be penalized, not rewarded.
When risk aversion is running high, investors will perform extensive due diligence, make conservative assumptions, apply skepticism and deny capital to risky schemes.
But when risk tolerance is widespread instead, these things will fall by the wayside and deals will be done that set the scene for subsequent losses.
Simply put, risk is low when risk aversion and risk consciousness are high, and high when they’re low.
The third is that risk is often hidden and thus deceptive.
Loss occurs when risk – the possibility of loss – collides with negative events. Thus the riskiness of an investment becomes apparent only when it is tested in a negative environment. It can be risky but not show losses as long as the environment remains salutary. The fact that an investment is susceptible to a serious negative development that will occur only infrequently – what I call “the improbable disaster” – can make it appear safer than it really is. Thus after several years of a benign environment, a risky investment can easily pass for safe. That’s why Warren Buffett famously said, “. . . you only find out who’s swimming naked when the tide goes out.”
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Full Oaktree letter to investors: