Friday, September 19, 2014

Howard Marks on Risk

From the latest memo by Howard Marks of Oaktree Capital:

"Volatility is the academic's choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in calculations and models of modern finance theory."

He then adds, not surprisingly, that volatility can "be an indicator or symptom of riskiness and even a specific form of risk" but "it falls far short as 'the' definition of investment risk."

The primary investment risk is the permanent loss of capital. Investors must be compensated sufficiently for that possibility. Well, volatility reveals nothing of real utility when it comes to making that assessment.

The problem is that, unlike volatility, actual risks can't really be quantified. Now, some will contend that risks can in fact be quantified but Marks argues, I think convincingly, that they cannot be. My view is that risk can be, best case, estimated in a meaningful but, more or less, qualitative way and cannot be known with any precision.

Marks writes that not only are risks not quantifiable a priori, they can't even really be known afterwards. This might seem odd but think of it this way: When an investment is sold, the investor knows specifically what the return ended up being. That doesn't mean that investor really understands the actual risk that was taken in order to get the now known result. The actual outcome was just one possible outcome among many. The risk and likelihood of a loss remains not quantifiable even after the sale is complete.

There's just no easy way to quantify the risks beforehand. Worse yet, it's not even really possible to quantify the risks after something has happened. Marks mentions that John Kenneth Galbraith believed that forecasters could not reliably predict the future and, as a result, necessarily fell into one of two categories:

"Those who don't know -- and those who don't know they don't know."

The same could be said about those who think most risks can actually be meaningfully measured.

This might at first all seem a bit unworkable, but I believe investing well requires getting comfortable with the subjective and qualitative nature of risk assessment. Time and energy should be directed at what an investor can actually control. Evaluating risk effectively is terribly important but the limits on what can be known and predicted are significant. Recognition of this should logically lead to less attention being paid to the many prognosticators and, instead, more focus on improving the investment process. Every aspect of investment decision-making needs to be continuously developed. Forecasts are mostly distraction.

It is possible to effectively deal with an uncertain future even if there's no reliable way to predict what's specifically going to happen. The many uncertainties can be dealt with by learning to roughly, but meaningfully, estimate the range of possible future outcomes and approximate probabilities.

Marks says that the estimation of risk "will by necessity be subjective, imprecise and more qualitative than quantitative (even if it's expressed in numbers)."

Volatility is totally insufficient as a measure of investment risk but has the advantage of being easily quantifiable. It's widespread use comes mostly down to that and not validity. Here's how Charlie Munger explained it once in a speech at UC Santa Barbara:

"...practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." 

Later in the memo Marks mentions a quote by Elrod Dimson:*

"Risk means more things can happen than will happen."

Marks then refers to something he wrote back in 2007:**

"...the history that took place is only one version of what it could have been."

So that means "the relevance of history to the future is much more limited than may appear to be the case."

With so much necessarily unknown and unknowable it quickly becomes clear -- or should become clear -- why, for investors, margin of safety is such a crucial principle. Buying an asset far below a conservative estimate of value offers some protection, up to a point at least, against uncertainties. This usually means lots of waiting since, under normal economic conditions, assets don't generally become extremely mispriced on the low side. Some real economic difficulties is usually required. This also means that it's crucial to be able to act decisively when something finally sells at a big discount. You can bet that there'll either be broad-based economic turmoil or troubles that are specific to the asset itself. So the analytical work has to be done well in advance. Temperamental factors will also play a big role. Those who can't resist being influenced by things like the media echo chamber -- whether cognitively, emotionally, or both -- aren't likely to make great investment decisions when it counts.

Sometimes the worst case scenario is so intolerable that it's necessary to avoid an investment with otherwise lots of potential upside. In other words, even a very large margin of safety would prove insufficient. The example of a skydiver who's successful 95% of the time is mentioned in the memo. That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time. There will be times where there's just no way to know the range of possible outcomes (sometimes due to investor limitations, sometimes due to external factors). The risk versus reward may in fact be very favorable, but it's just not clear so decisive action cannot be taken.

A more or less traditional view is that taking more risk is the path to outsized returns. Well, that's just not correct. Those that continue to think along these lines are likely to end up with rather disappointing results. More from Marks:

"We hear it all the time: 'Riskier investments produce higher returns' and 'If you want to make more money, take more risk.'

Both of these formulations are terrible. In brief, if riskier investments could be counted on to produce higher returns, they wouldn't be riskier."

On page 6 of the memo, Marks provides two very useful graphics to better explain the relationship between risk and return. The first graphic shows the rather conventional -- if not necessarily correct -- positive correlation between risk and return.

Well, the correlation between risk and return is sometimes positive, it's just not inevitably positive. I've covered this in prior posts but, as far as I'm concerned, it can't be repeated or emphasized enough.

The second graphic portrays the risk-return relationship in a much more useful fashion. It shows that increased risk increases the range of outcomes...not necessarily returns.

So volatility happens to be totally deficient as a measure of investment risk but that doesn't mean it's inconsequential:

"When you're under pressure, the distinction between 'volatility' and 'loss' can seem only semantic."

Price plays the key role in managing the many mostly not quantifiable risks that are an inevitable part of the investment process:

"...the riskiest thing is overpaying for an asset (regardless of its quality), and the best way to reduce risk is by paying a price that's irrationally low (ditto). A low price provides a 'margin of safety', and that's what risk-controlled investing is all about. Valuation risk should be easily combatted, since it's largely within the investor's control. All you have to do is refuse to buy if the price is too high given fundamentals.'Who wouldn't do that?' you might ask. Just think about the people who bought into the tech bubble."

The following from Warren Buffett's The Superinvestors of Graham-and-Doddsville comes to mind:

"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.

One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy. 

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million..."

I think Howard Marks writes about risk just about as good as, if not better, than anyone else. In the memo, he walks through no less than 24 different forms of risk. Many of these are related to the "main risk" -- that being the possibility capital will be permanently lost. Sometimes, trying to minimize one type of risk increases another type of risk. That's part of what makes the investment process so challenging and, well, so enjoyable.

Overall, Marks has produced an impressively comprehensive memo.

Reading it is time well spent.

Some will want to focus on how to generate the biggest possible returns.

That will usually be a mistake.

The focus should be on, first and foremost, investment risk and how to deal with it.


Related posts:
-Grantham on Efficient Markets, Bubbles, and Ignoble Prizes
-Efficient Markets - Part II
-Risk and Reward Revisited
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Buffett: Why Stocks Beat Bonds
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Dimson is a professor at London Business School.

** From No Different This Time -- The Lessons of '07 (December 2007).
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