Howard Marks: The Two Main Risks in the Investment World

From this memo to clients written by Howard Marks:

Howard Marks: Warning Flags

"...there are two main risks in the investment world: the risk of losing money and the risk of missing opportunity. You can completely avoid one or the other, or you can compromise between the two, but you can't eliminate both. One of the prominent features of investor psychology is that few people are able to (a) always balance the two risks or (b) emphasize the right one at the right time. Rather, at the extremes they usually obsess about the wrong one...and in so doing make the other the one deserving attention. 

During bull markets, when asset prices are elevated, there's great risk of losing money. And in bear markets, when everything's at rock bottom, the real risk consists of missing opportunity. Everyone knows these things. But bull markets develop for the simple reason that most people are buying – ignoring the risk of loss in order to keep from missing opportunity – just when elevated prices imply losses later. Likewise, markets reach their lows because most people are selling, trying to avoid further losses and ignoring the bargains that are everywhere." - Howard Marks

During bull markets, more often than not, it's the potential returns and missed opportunities that grab the headlines and capture the imagination.

In a bear markets risk of loss is front of mind.

It's best to not fall prey to these tendencies.

In good times, potential returns will always get more play than the risk of loss. It is not difficult to understand why this is the case. The simple fact is that risks are almost always hard to quantify and frequently invisible whereas returns are easy to reveal in black and white.

So naturally many investors flock to the highest (easily verifiable) returns without looking at it in the context of risks that may or may not have been taken. A mistake in my view that only becomes plainly obvious over the long haul.

There are always very real risks that in one or several instances happen to not materialize in a meaningful way (often leading to overconfidence when none is warranted). Crossing a canyon on a barrier free one lane bridge at 150 MPH may have worked out the last time but repeat that behavior enough and I'm certain performance will eventually suffer just a bit. Unfortunately, the risks in most investments are usually not nearly as plain. In fact, the many adverse things that can happen in the future are unknowable or at least hard to foresee.

In other words, that the latent risk did not happen to materialize in a particular instance make it no less real.

Investors that become good at managing the risks that can lead to permanent capital loss from a portfolio have a huge advantage.

"..Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger

Business executives and investors (professional or not) often do not think about this carefully enough and end up paying for it. There are few subjects more important than this but it gets little attention. Why?

People see big returns and their eyes light up. Talk about risk and they fall asleep.

So what's the easiest way to manage investment risks leading to permanent loss of capital when many of the risk in the future are nearly impossible to anticipate?

Price.

"In the same way that expanded risk tolerance accompanies appreciated asset prices and contributes to the risk of loss, so does risk aversion tend to rise in times of depressed prices, increasing the risk of missed opportunity. When people refuse to buy assets regardless of their low prices, they miss out on the best, lowest-risk returns of the cycle." - Howard Marks

Howard Marks: Warning Flags

A business selling at a price that is a substantial discount to value (conservatively calculated) protects the investor from unforeseen and the unforeseeable risks.

A quality business bought at a substantial premium to value can actually be more risky than a troubled business selling at what is a plain discount.

So it's price that often dictates the risks that an investor is takes. That doesn't mean one shouldn't think carefully about all the risks involved in an investment. It's just humble recognition that you cannot anticipate everything and the only thing there to protect you is a really low price compared to likely future value.

Adam

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