In my effort to understand more about market cycles and risks, I came across a couple of books by billionaire investor ‘Howard Marks’. I already have shared my learning s from the book ‘Learning from the book “Mastering the Market Cycle” by Howard Marks.‘. I will be sharing the learning from his other book “The most important thing” in 2 parts, one is about Risk and the other will be about everything else. In this blog, I will be sharing the risk part.
Howard Marks has spent 3 chapters of the total 19 chapters on explaining about investment risks. And rightly so.
Learning from the book “The Most Important Thing” by ‘Howard Marks’: RISKS
As an investor we always look for reward i.e. how much do we expect for any particular share price to go up, without considering the risk factor involved i.e. likelihood of price going down or of potential loss.
Since investing consists on only one thing: dealing with future. In the market, the current stock prices factor all the variables impacting the company, the price appreciation we are expecting is on the basis of future performance of the company. And anything that is to do with the future involves uncertainty and that is called as risk.
Understanding Risk
According to Howard Marks, there are 3 steps to deal with risk:
1. The first step consists of understanding the risk
2. The second step is recognizing when the risk is high
3. Final step is controlling it
How to measure risk?
1. It is more of a matter of opinion.
2. It is not possible to quantify. For the same investment, some would think that the risk is high whereas others will think it is low.
3. It is deceptive. Non-likely event cant be factored in. But in case that occurs, it will be quite damaging to anyone’s portfolio.
Now, that implies risk is very difficult to measure. The author points out that correctly ascertaining the value of a company and the current price level is the most reliable way to measure risk.
And according to Howard Marks, buying cheap is the most reliable way to avoid risk. Risks comes primarily from buying at high prices.
But when you think about what Charlie Munger( Vice-chairman- Berkshire Hathways) always says ‘A great business at a fair price is more superior to a fair business at great price.’ And I would always go with the later.
When we look at Howard Marks point, we can consider not buying something at a exorbitant prices. And most importantly I feel that understanding the business and the how the business gets impacted by the macro-environment is of larger importance.
When markets are booming, the best results often goto those who take the most risk. As Nassim Nicholas Taleb calls them “Lucky Idiots” Just because the investment worked it does not mean it was not risky.
Learning from the book “The Most Important Thing” by ‘Howard Marks’: RISKS
For me the most important learning from these chapters was :
“People usually expect the future to be like the past and underestimate the potential for change.”
When things have been going well for a while- People tend to say ‘Risk is my friend. The more risk I take, the greater my return will be. I would like more risk,
When people are not afraid of risk, they will accept a risk without being compensated for doing so and risk compensation will disappear.
Returns alone over short periods of time-says very little about the quality of investment decisions. I personally have realized that.
If riskier investments reliably produced higher returns, they would not be riskier. In simple words riskier investments lacks reliability of returns.
Learning from the book “The Most Important Thing” by ‘Howard Marks’: RISKS
The author gives an example of 2005-07, when things were going good and investors/analysts were gung-ho based on the following facts and assuming things to be the same forever:
1. The risk of economic cycles has been eased by adroit central bank management
2. Because of globalization, risk has been spread worldwide rather than being concentrated
3. Securitization & syndication have distributed risk to many market participants.
4. Leverage has become less risky because of low-interest rates and friendly debt terms
5. Risk can be hedged
6. Improvements in computers, mathematics, and modeling have made the markets better understood and thus less risky
But despite all these factors, what the sub-prime crisis did to the entire world economy is still fresh among many. Those who had seen the crisis would be much better prepared now.
The point the author is trying to make is that when things are going too good, something always comes up and destroys the party.
Learning from the book “The Most Important Thing” by 'Howard Marks': RISKS
Some other pointers
Importance of managing risk is widely underappreciated. Risk is the potential for loss if things go wrong. As long as things go well, loss does not arise. Risk gives rise to loss only when the negative events occur in the environment.
Risk control is invisible in good times but still essential, since good times can so easily turn into bad times.
If a poor builder has built a building with construction flaws, till the time there is no earthquake, you can’t tell the difference between good and bad.
Risky assets can make good investments if they are cheap enough.
Careful risk controllers know they don’t know the future. They know it can include some negative outcomes but don’t know bad they might be, or exactly what their probabilities are.
Volatility + Leverage= Dynamite
Reality is far more vicious than Russian roulette. It delivers the fatal bullet rather infrequently where people have forgotten about the risk.
Learning from the book “The Most Important Thing” by ‘Howard Marks’: RISKS
The learning here is that we need to look at the other side of the coin i.e. what if things don’t go the way we want it to. We can ask few questions ourselves?
1. Are all the good aspects of the company already factored into the price?
2. Are market participants too positive about the future of the booming index?
Stay alert for occasions when a market has reached an extreme -> Adjust our behavior in response to-> Refuse to fall in line with the herd behavior
Things always move in a cycle..be it life or the market.
Howard Marks on Risk
Further reading: