The Most Important Thing: Uncommon Sense for the Thoughtful Investor (Columbia Business School Publishing)

by Howard Marks

The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so . . . and risk compensation will disappear. This is a simple and inevitable relationship.

So a prime element in risk creation is a belief that risk is low, perhaps even gone altogether. That belief drives up prices and leads to the embrace of risky actions despite the lowness of prospective returns.

In 2005–2007, belief that risk had been banished caused prices to rise to bubble levels and investors to participate in what later turned out to be risky activities. This is one of the most dangerous of all processes, and its tendency to recur is remarkable.

The bottom line is that tales like this one about risk control rarely turn out to be true. Risk cannot be eliminated; it just gets transferred and spread. And developments that make the world look less risky usually are illusory, and thus in presenting a rosy picture they tend to make the world more risky. These are among the important lessons of 2007.

Worry and its relatives, distrust, skepticism and risk aversion, are essential ingredients in a safe financial system. Worry keeps risky loans from being made, companies from taking on more debt than they can service, portfolios from becoming overly concentrated, and unproven schemes from turning into popular manias. When worry and risk aversion are present as they should be, investors will question, investigate and act prudently. Risky investments either won’t be undertaken or will be required to provide adequate compensation in terms of anticipated return.

But only when investors are sufficiently risk-averse will markets offer adequate risk premiums. When worry is in short supply, risky borrowers and questionable schemes will have easy access to capital, and the financial system will become precarious. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety. Clearly, in the months and years leading up to the crisis, few participants worried as much as they’re supposed to.

That’s why the yield curve, which in reality is a portion of the capital market line, normally slopes upward with the increase in asset life.

big problem for investment returns today stems from the starting point for this process: The riskless rate isn’t 4 percent; it’s closer to 1 percent....

The lower level of the line is explained by the low interest rates, the starting point for which is the low riskless rate. After all, each investment has to compete with others for capital, but this year, due to the low interest rates, the bar for each successively riskier investment has been set lower than at any time in my career.

Not only is the capital market line at a low level today in terms of return, but in addition a number of factors have conspired to flatten it. (This is important, because the slope of the line, or the extent to which expected return rises per unit increase in risk, quantifies the risk premium.) First, investors have fallen over themselves in their effort to get away from low-risk, low-return investments.... Second, risky investments have been very rewarding for more than twenty years and did particularly well in 2003. Thus, investors are attracted more (or repelled less) by risky investments than perhaps might otherwise be the case, and require less risk compensation to move to them.... Third, investors perceive risk as being quite limited today.

In summary, to use the words of the “quants,” risk aversion is down. Somehow, in that alchemy unique to investor psychology, “I wouldn’t touch it at any price” had morph...

The reality of risk is much less simple and straightforward than the perception. People vastly overestimate their ability to recognize risk and underestimate what it takes to avoid it; thus, they accept risk unknowingly and in so doing contribute to its creation. That’s why it’s essential to apply uncommon, second-level thinking to the subject.

Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns.

The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.

Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the “perversity of risk.”

I’m firmly convinced that investment risk resides most where it is least perceived, and vice versa:

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.

This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them.... Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.

When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.

Whatever few awards are presented for risk control, they’re never given out in good times. The reason is that risk is covert, invisible. Risk—the possibility of loss—is not observable. What is observable is loss, and loss generally happens only when risk collides with negative events.

The important thing here is the realization that risk may have been present even though loss didn’t occur. Therefore, the absence of loss does not necessarily mean the portfolio was safely constructed. So, risk control can be present in good times, but it isn’t observable because it’s not tested. Ergo, there are no awards.

Bottom line: risk control is invisible in good times but still essential, since good times can so easily turn into bad times.

An inefficient market can also allow a skilled investor to achieve the same return as the benchmark while taking less risk, and I think this is a great accomplishment (figure 7.2). Here the manager’s value added comes not through higher return at a given risk, but through reduced risk at a given return. This, too, is a good job—maybe even a better one.

How do you enjoy the full gain in up markets while simultaneously being positioned to achieve superior performance in down markets? By capturing the up-market gain while bearing below-market risk . . . no mean feat.

Bearing risk unknowingly can be a huge mistake, but it’s what those who buy the securities that are all the rage and most highly esteemed at a particular point in time—to which “nothing bad can possibly happen”—repeatedly do. On the other hand, the intelligent acceptance of recognized risk for profit underlies some of the wisest, most profitable investments—even though (or perhaps due to the fact that) most investors dismiss them as dangerous speculations.

I’ve said for years that risky assets can make for good investments if they’re cheap enough. The essential element is knowing when that’s the case. That’s it: the intelligent bearing of risk for profit, the best test for which is a record of repeated success over a long period of time.

Extreme volatility and loss surface only infrequently. And as time passes without that happening, it appears more and more likely that it’ll never happen—that assumptions regarding risk were too conservative. Thus, it becomes tempting to relax rules and increase leverage. And often this is done just before the risk finally rears its head. As Nassim Nicholas Taleb wrote in Fooled by Randomness: Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security. . . . Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. . . . One is thus capable of unwittingly playing Russian roulette—and calling it by some alternative “low risk ” name.

The financial institutions played a high-risk game in 2004–2007 thinking it was a low-risk game, all because their assumptions on losses and volatility were too low. We’d be watching an entirely different picture if only they’d said, “This stuff is potentially risky. Since home prices have gone up so much and mortgages have been available so easily, there just might be widespread declines in home prices this time. So we’re only going to lever up half as much as past performance might suggest.”

If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year [2008], it’s possible no leverage would ever be used. Is that a reasonable reaction? (In fact, it’s possible that no one would ever invest in these asset classes, even on an unlevered basis.)

So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events. But a generation isn’t forever, and there will be times when that standard is exceeded. What do you do about that? I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007–2008 prove there’s no easy answer.

“VOLATILITY + LEVERAGE = DYNAMITE,” DECEMBER 17, 2008

Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.

Rick Funston of Deloitte & Touche said in the article that prompted this memo (“When Corporate Risk Becomes Personal,” Corporate Board Member, 2005 Special Supplement), “You need comfort that the . . . risks and exposures are understood, appropriately managed, and made more transparent for everyone.... This is not risk aversion; it is risk intelligence.” That’s what Oaktree strives for every day.

In investing, as in life, there are very few sure things. Values can evaporate, estimates can be wrong, circumstances can change and “sure things” can fail. However, there are two concepts we can hold to with confidence: • Rule number one: most things will prove to be cyclical. • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

The basic reason for the cyclicality in our world is the involvement of humans. Mechanical things can go in a straight line. Time moves ahead continuously. So can a machine when it’s adequately powered. But processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events. They reverse (rather than going on forever) because trends create the reasons for their own reversal. Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.

Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness. Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled.

Look around the next time there’s a crisis; you’ll probably find a lender. Overpermissive providers of capital frequently aid and abet financial bubbles. There have been numerous recent examples where loose credit contributed to booms that were followed by famous collapses: real estate in 1989–1992; emerging markets in 1994–1998; Long-Term Capital Management in 1998; the movie exhibition industry in 1999–2000; venture capital funds and telecommunications companies in 2000–2001. In each case, lenders and investors provided too much cheap money and the result was overexpansion and dramatic losses. In Field of Dreams, Kevin Costner was told, “If you build it, they will come.” In the financial world, if you offer cheap money, they will borrow, buy and build—often without discipline, and with very negative consequences.

Cycles will never stop occurring. If there were such a thing as a completely efficient market, and if people really made decisions in a calculating and unemotional manner, perhaps cycles (or at least their extremes) would be banished. But that’ll never be the case.

One of my favorite books is a little volume titled Oh Yeah?, a 1932 compilation of pre-Depression wisdom from businessmen and political leaders. It seems that even then, pundits were predicting a cycle-free economy:

And then it turns out that the old rules do still apply, and the cycle resumes. In the end, trees don’t grow to the sky, and few things go to zero. Rather, most phenomena turn out to be cyclical.

The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.

Investment markets follow a pendulum-like swing: • between euphoria and depression, • between celebrating positive developments and obsessing over negatives, and thus • between overpriced and underpriced. This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a “happy medium.”

the pendulum also swings with regard to greed versus fear; willingness to view things through an optimistic or a pessimistic lens; faith in developments that are on-the-come; credulousness versus skepticism; and risk tolerance versus risk aversion.

When investors in general are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-averse, prices can offer more return than risk.

fact, I’ve recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both.

Thus, the last several years have provided an unusually clear opportunity to witness the swing of the pendulum . . . and how consistently most people do the wrong thing at the wrong time. When things are going well and prices are high, investors rush to buy, forgetting all prudence. Then, when there’s chaos all around and assets are on the bargain counter, they lose all willingness to bear risk and rush to sell. And it will ever be so.

Very early in my career, a veteran investor told me about the three stages of a bull market. Now I’ll share them with you. • The first, when a few forward-looking people begin to believe things will get better • The second, when most investors realize improvement is actually taking place • The third, when everyone concludes things will get better forever Why would anyone waste time trying for a better description? This one says it all. It’s essential that we grasp its significance.

That’s why I love the old adage “What the wise man does in the beginning, the fool does in the end.” Most important, in the late stages of the great bull markets, people become willing to pay prices for stocks that assume the good times will go on ad infinitum.

One of these days, though, we’ll reach the third stage, and the herd will give up on there being a solution. And unless the financial world really does end, we’re likely to encounter the investment opportunities of a lifetime. Major bottoms occur when everyone forgets that the tide also comes in. Those are the times we live for.