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Howard Marks: move forward with caution

Howard Marks established Oaktree Capital in 1995, which now manages over US$90 billion with a primary emphasis on risk control in a limited number of sophisticated investment specialties. In 2011, he published the book The Most Important Thing: Uncommon Sense for the Thoughtful Investor. Marks is best known in the global investment community for his ‘Oaktree Memos’ to clients which detail investment strategies and insights into the economy. His latest memo, Risk Revisited Again, is an update on his views on risk management, but it’s a weighty 21 pages. This note extracts some highlights.

Risk is not volatility

Marks has long argued that volatility is a poor measure of risk, and that investors fear a permanent loss rather than volatility. He expands this idea:

“Permanent loss is very different from volatility or fluctuation. A downward fluctuation – which by definition is temporary – doesn’t present a big problem if the investor is able to hold on and come out the other side. A permanent loss – from which there won’t be a rebound – can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing – whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but we never get a chance to undo a permanent loss.”

Quoting Peter Bernstein on taking more risk

Marks takes inspiration from Peter Bernstein’s writings, and quotes him at length, including:

“Can we sustain the low-risk character of the environment when it leads many investors to take high risks and to overvalue risky assets in search for higher returns? ... The more risk we take because we believe the environment is low-risk in character, the less the environment continues to be low-risk in character.”

Marks argues that the future is not knowable, although most people who forecast markets seem to think it is. The key role played by human behaviour creates a great deal of randomness and weak linkages. He quotes Bernstein again:

“If you accept that the underlying processes affecting economics, business and market psychology are less than 100% dependable, as seems obvious, then it follows that the future isn’t knowable ... We like to rely on history to justify our forecasts of the long run, but history tells us over and over again that the unexpected and the unthinkable are the norm, not an anomaly. That is the real lesson of history.”

What makes a good investor if the future is unknowable?

“Only investors with unusual insight can regularly divine the probability distribution that governs future events and sense when the potential returns compensate for the risks that lurk in the distribution’s negative left-hand tail. 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 ... Even though many things can happen, only one will.”

What does a conservative investor do in the current low rate market?

Marks says most people focus on the risk of losing money, but the risk of missing opportunities is just as important.

“Some investors with needs – particularly those who live on their income, and especially in today’s low-return environment – face a serious conundrum. If they put their money into safe investments, their returns may be inadequate. But if they take on incremental risk in pursuit of a higher return, they face the possibility of a still-lower return, and perhaps of permanent diminution of their capital, rendering their subsequent income lower still. There is no easy way to resolve this conundrum … investors face not one but two major risks: the risk of losing money and the risk of missing opportunities. Either can be eliminated but not both.”

His solution lies in taking more credit risk, illiquidity risk, concentration risk and leverage risk, based on the hope that investor skill will produce success. However, such investing exposes the portfolio to a broader range of outcomes, including bad ones. If an investor does not have the skills to manage these risks, they must introduce another – manager risk.

“I want to point out that whereas risk control is indispensable, risk avoidance isn’t an appropriate goal. The reason is simple: risk avoidance usually goes hand-in-hand with return avoidance. While you shouldn’t expect to make money just for bearing risk, you also shouldn’t expect to make money without bearing risk.”

Preserving wealth in the current market

Marks worries money has flooded into riskier investments because interest rates are so low, with some investors dropping their caution and reducing standards. He concludes:

“It’s the job of investors to strike a proper balance between offense and defense, and between worrying about losing money and worrying about missing opportunity. Today I feel it’s important to pay more attention to loss prevention than to the pursuit of gain. For the last four years Oaktree’s mantra has been “move forward, but with caution”. At this time, in reiterating that mantra, I would increase the emphasis on those last three words … Although I have no idea what could make the day of reckoning come sooner rather than later, I don’t think it’s too early to take today’s carefree market conditions into consideration. What I do know is that those conditions are creating a degree of risk for which there is no commensurate risk premium. We have to behave accordingly.”


Graham Hand is Editor of Cuffelinks. This article is for educational purposes only and does not consider the personal financial circumstances of any investor. The above extracts should be read in the context of the entire paper, which is the copyright of Oaktree Capital Management L.P.


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