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

by Howard Marks

“There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” That’s one of the most important things you can know about investment risk.

Finally and importantly, most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk ’s all about.

“Jill Fredston is a nationally recognized avalanche expert. . . . She knows about a kind of moral hazard risk, where better safety gear can entice climbers to take more risk—making them in fact less safe.” Like opportunities to make money, the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions. Regardless of what’s designed into market structures, risk will be low only if investors behave prudently.

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.

In How Markets Fail, John Cassidy describes classic psychology experiments conducted by Swarthmore’s Solomon Asch in the 1950s. Asch asked groups of subjects to make judgments about visual exhibits, but all but one of the “subjects” in each group were shills working for him. The shills intentionally said the wrong thing, with dramatic impact on the one real subject. Cassidy explains, “This setup placed the genuine subject in an awkward spot: [As Asch put it,] ‘Upon him we have brought to bear two opposed forces: the evidence of his senses and the unanimous opinion of a group of his peers.’ ” A high percentage of the real subjects ignored what they saw and sided with the other group members, even though they were obviously in the wrong. This indicates the influence of the crowd and thus suggests reservations about the validity of consensus decisions.