Lessons on Risk from “The Most Important Thing” by Howard Marks

by | Aug 26, 2022

“Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable”

– Howard Marks, The Most Important Thing

Howard Marks is the chairman and co-founder of Oaktree Capital Management, a fund with over $159 billion in assets under management. Marks has over 40 years of market experience and is considered among the best value investors.

The title is deceptive because Marks doesn’t believe there is one most important thing. Rather there are 20 things with equal importance to investing success. Marks spends a lot of time thinking about risk as is evident in his book. Three of the most important things are about risk. Here’s what I learned about risk from The Most Important Thing.

The capital market line is misleading. 

Chances are you have seen the capital market line shown below. It is supposed to compare the return an investor expects based on the risk of the investment. The problem is It makes it appear as though all you need to do to get better returns is take more risk. “But riskier investments cannot be counted on to deliver high returns. Why not? It’s simple: if riskier investments reliably produced higher returns, they wouldn’t be riskier!” 

Capital Market Line

“The correct formulation is that in order to attract capital, riskier investments have to offer the prospect of higher returns. But there’s absolutely nothing to say those prospective returns have to materialize”.

Marks’ preferred capital market line

Marks prefers this adapted chart. It shows that low-risk investments offer low returns and the variation in these returns is likely to be small. High-risk investments offer high returns but the variation in these returns is also high. 

 “Riskier investments are those for which the outcome is less certain. That is, the probability distribution of returns is wider.”

“When fairly priced riskier investment should entail:

  • Higher expected returns
  • The possibility of lower returns, and
  • In some cases the possibility of losses”

Academics Define Risk Incorrectly

Academics define risk as volatility. It is often referred to as beta. Marks thinks this is an inappropriate measure of risk.

“I’ve never heard anyone at Oaktree – or anywhere for that matter – say, ‘I won’t buy it because its price might show big fluctuations,’ or “ I won’t buy it because it might have a down quarter’”.

The risk people are worried about is the risk of loss of capital or a low return. 

“‘I need more upside potential because I’m afraid I could lose money’ makes an awful lot more sense than ‘I need more upside potential because I’m afraid the price might fluctuate’”.

Risk isn’t necessarily caused by weak fundamentals

“A fundamentally weak asset –  a less than stellar company’s stock, a speculative grade bond or a building in the wrong part of town – can make for a very successful investment if bought at a low enough price.”.

Risk is subjective

“With any given investment, some people will think the risk is high and others will think it’s low. Some will state it as the probability of not making money, and some as the probability of losing a given fraction of their money. Some will think of it as the risk of losing money over one year, and some as the risk of losing money over the entire holding period”. 

Risk is caused by the price paid

“Investment risk comes primarily from too-high prices and too-high prices often come from excessive optimism and inadequate scepticism and risk aversion.”

“When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it is not risky at all. When everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky”.

“This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something is 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”.

An equal return with lower risk is just as impressive as a higher return with equal risk.

“Most observers think the advantage of inefficient markets lies in the fact that a manager can take the same risk as the benchmark and earn a superior rate of return… but I think this is only half the story… an efficient market can also allow a skilled investor to achieve the same return as the benchmark while taking less risk.”

Often it’s impossible to know how risky an investment is until disaster strikes

“Risk is covert, invisible. The possibility of loss – is not observable. What is observable is loss and loss generally happens only when risk collides with negative events”.

“Risk is the potential for things to go wrong. As long as things go well, loss does not arise”.

“A good builder is able to avoid construction flaws, while a poor builder incorporates construction flaws. When there are no earthquakes you can’t tell the difference”. 

Investors shouldn’t be afraid of risk, but they must be aware of its existence. We should welcome risk but only at the right price and the right expected return. You can quite easily avoid all risk by investing in AAA Government bonds, but you would also be forgoing any returns above the risk-free rate. Intelligent investors practice risk control, not risk avoidance. 

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