Introduction: Understanding Risk
The concept of risk is integral to the world of investing. But how we approach risk can be just as crucial as the risk itself. As Howard Marks eloquently puts it, this course is not about what to think, but how to think about risk. This subtle yet important distinction is critical for investors aiming to thrive in uncertain environments.
Redefining Risk: Beyond Volatility
"Risk is not what happens to you; it's how you respond." — Anonymous
For a long time, academic circles defined risk in terms of volatility. However, Marks argues that volatility is merely a symptom of risk, not the essence. The real risk lies in the possibility of loss. In practical terms, this means potential loss in value of an investment, which is what truly matters to investors and demands compensation.
The inability to quantify risk precisely raises questions for investors accustomed to relying on numbers. But as Marks points out, while volatility is quantifiable, it does not necessarily capture the true essence of risk. Real-world risk encompasses a range of possibilities that are not easily predicted or controlled.
Asymmetry in Investment Returns
Marks offers a detailed analysis of investment performance, emphasizing what he calls "asymmetry" — achieving market-like returns in good times and reducing losses in bad times. Consider different managers managing a portfolio:
- Manager A: Matches market gains and losses. Adds no real value.
- Manager B: Exceeds market gains but also suffers greater losses. Again, no added value.
- Manager C: Gains during up markets but falls less in down markets. This exemplifies asymmetry, adding true value.
Asymmetry here is about managing downside risks while capturing upside potential, a subtle but powerful approach to investing.
The Probability of Loss
Marks reiterates that risk should be understood as the probability of loss. He argues that risk isn't quantifiable in advance or even after the fact. Even a profitable venture may have been risky. Therefore, a loss might not automatically indicate a mistake unless the underlying probability and risk profile are assessed.
Risk Isn't Just Loss: It's Multidimensional
Beyond the probability of loss, risk involves missing opportunities. There lies the danger of not taking enough risk and missing out on valuable gains. Thus, the reluctance to embrace risk can be as harmful as reckless risk-taking itself.
Ignorance and Risk: A Philosophical Perspective
Utilizing philosophical insights from thinkers like Peter Bernstein and GK Chesterton, Marks explores how ignorance contributes to risk. Bernstein notes that "risk says we don't know what's going to happen," highlighting that our very ignorance about the future's specific outcomes nurtures risk.
Tail Events and Misconceptions
Marks shares that financial history has occurred mostly within predictable boundaries, yet notable shocks — tail events — often fall outside these expectations, challenging conventional models.
Thinking About Risk: Four Principles
- More Can Happen than Will Happen: Categorically, more scenarios can occur than will materialize. The very nature of this introduces risk.
- View Future as Probabilities, Not Certainties: Consider possible outcomes as probabilities rather than fixed certainties. This mindset allows more flexible response to potential risks.
- Knowledge of Probabilities Doesn't Ensure Outcomes: Even when probabilities are known, they don't guarantee predictions. This captures the essence of investment uncertainty.
- Expected vs. Actual: What actually transpires is just one of numerous possibilities. The gap between expected and actual outcomes presents both challenges and opportunities for the discerning investor.
The Complexity of Risk
Risk often behaves counterintuitively:
- Removed Controls: In some scenarios like traffic in Drachten, Holland, removing controls led to more cautious behavior and fewer accidents. It suggests how perceived safety can potentially lead to riskier behavior.
- Perceiving Safety Can Increase Risk: As more advanced gear allows climbers to attempt more dangerous feats, the risk of climbing accidents has not decreased despite improved safety equipment. Human behavior, in assuming lesser risk due to better protection, sometimes inadvertently increases total risk exposure.
These examples underline Marks’ belief that risk isn't merely intrinsic but also shaped largely by the psychology and behavior of market participants.
The Perversity of Risk
Marks emphasizes that greater risk consciousness often reduces real risk. For instance, as asset prices decline, perceived risk increases though actual risk decreases due to lower prices, thus presenting opportunities. Conversely, rising asset prices, perceived as less risky, actually signal increased risk levels — a counterintuitive phenomenon many investors fail to recognize.
Risk Management: Beyond Mitigation
Effective risk management doesn't aim to eradicate risk but to control it. The most skilled investors can construct portfolios that perform well even in adverse conditions. Marks refers to this ability as the "Cornerstone of Superior Investing." It's about creating robust portfolios that capture upside but are resilient to downturns.
Conclusion: Embracing Risk Wisely
Marks concludes by urging that risk is inescapable if one seeks success in investing. Yet it must be managed judiciously. Avoidance equates to missed opportunities. Thus, investors are encouraged to focus on the intelligent bearing of risk, leveraging expert insights and subjective judgments to guide investment decisions.
The essence of superior investing doesn’t simply lie in chasing returns but in understanding, managing, and sometimes embracing the risks involved. Thus, a superior grasp of risk leads to better decision-making in investments, culminating in remarkable long-term implications.
The real challenge is not just in bearing risk, but in controlling it intelligently—achieving reward without undue exposure to loss.
INVESTMENT STRATEGY, YOUTUBE, DECISION MAKING, INVESTING, RISK MANAGEMENT, HOWARD MARKS, POSSIBILITY OF LOSS, BEHAVIORAL FINANCE, ASYMMETRY, PROBABILITY, PHILOSOPHY