How to think about risk

hi I'm Howard marks and this is how to think about [Music]
risk the title of this class is how to think about risk that's an important
title not what to think how to think the first question is what is risk risk in
my opinion is the ultimate test of an Investor's skill the return alone doesn't tell you how good a job the
manager did the key question is you see the return you must ask how much risk
did the manager bear to get that return now let's look at this range of managers
what we posit is that the market is up 10% or down 10% now let's look at some
individual managers the first one is up 10 when the Market's up 10 and down 10
when the Market's down 10 ACC lishes nothing you might as well have invested in an index fund that emulates the
performance of the market no skill no value added now let's look at the second
one up 20 when the market goes up 10 down 20 when the market goes down 10 no
skill no value added just a lot of aggressiveness what about this one up five when the Market's up 10 down five
when the Market's down 10 again no selection ability no discernment no value added just defensiveness you don't
need help in achieving that and you sure shouldn't pay a lot for it but what about the next one he or she is up 15
when the Market's up 10 and down 10 when the Market's down 10 so in other words Market type losses on the downside but
Superior gains on the upside value added what I call asymmetry does better in the
good times than does poorly in the bad times but what about this one and I
think this is the most interest I think maybe it characterizes Me Maybe it char izes oak tree to some extent up 10 when
the Market's up 10 down five when the Market's down 10 so Market type gains in
the good times I personally think that performing with the market when it does
well is good enough and that's almost all the time nobody should have to beat
the market when it does well but if you can do that and at the same time be
ready to decline less when the market has it down spells I think that's
accomplishing something very [Music]
important I believe that risk is not volatility the academics developing
investment Theory largely at the University of Chicago in the early 60s just a couple of years before I got
there adopted volatility as their measure of risk I believe they did so
largely because volatility is readily quantifiable and nothing else is I think
volatility can be an indicator of the presence of risk a symptom if you will
but it's not risk itself so if risk is not volatility then what is it and in my
opinion and in the real world sense risk is the probability of loss I think this
is what most people mean when they say risk and I think that this is what people demand compensation for if
they're going to Bear it uh nobody sitting around at Oak Tree says well you
know uh we shouldn't make that investment because it might be volatile
or uh because it might be volatile we should demand a higher return no they
say that about the possibility of loss we're not going to make that investment because the possibility of loss is too
high or because of the possibility of loss we're going to demand a risk premium in terms of the return this is
risk the possibility of loss now another important question is is risk
quantifiable in advance and I believe it's not like most things occurring in
the future risk cannot be anything except a matter of opinion I was writing my first memo about risk in 2006 I wrote
about my belief that risk is not quantifiable in advance and then I hit
the return key and went on to the next section and wrote something I had never thought about before
my belief that risk is unquantifiable even after the fact and I think this is
a fascinating topic uh you buy something for a dollar and a year later you sell
it for $2 was it risky and the interesting thing is that you can't tell from the outcome a
profitable investment may or may not have been risky was it a safe investment
that in the case of my example was sure to double or was it a risky investment
where you got lucky in terms of the outcome and as I say you can't tell from
the outcome the bottom line is to me it's impossible to quantify risk in
advance or even in
hindsight the possibility of loss is not the only form of risk there are lots of forms of risk my last memo on the
general subject it's called risk Revisited again and I talk in there about 24 or 25 different forms of risk
some serious some facius some important some less important and obscure but
still it comes in many forms the risk of missing opportunities is another important risk in other words if you
think about it the risk of not taking enough risk another really important
form uh of risk I think one of the key risks in investing is the chance of
being forced out at the bottom which is a bigger mistake buying at the high and
seeing a decline or selling out at the low and missing out on the recovery
clearly it's the ladder if you buy at a high and you experience a decline if
you're able to hold throughout and not lose your nerve the next high is usually
higher than the last High the fact that you experienced a downward fluctuation might have been uncomfortable for a
little while but by the time the new high is achieved you're you're you're back to to your
cost and more but if you sell at the bottom and miss out on the subsequent
recovery that means you've gotten off the track of investing and uh may never get back on in my opinion selling at the
bottom it's the cardinal sin in investing [Music]
now I want to get a little philosophical one of my great Heroes Peter Bernstein
probably the best thinker in a philosophic sense and and a real investment Sage who sadly passed away
around 2009 one said essentially risk says we don't know what's going to
happen we walk every moment into the unknown he said there's a range of
outcomes and we don't know where the actual outcome is going to fall within the range and often we don't know what
the range is so in other words we have ignorance to varying degrees about what
the future holds and it is from this ignorance uh that risk ensues if we knew
what was going to happen by definition there would be no risk in the memo that I mentioned before risk Revisited again
there's a great quote uh that I got from a Peter Bernstein memo and I thought it
was so important that I took it over word for word in my memo it's from GK
Chesterton who was a English uh writer and he said the following and I'm going
to give it to you word for word uh because it's so important the real
trouble with this world of ours is not that it is an unreasonable world or even
that it is a reasonable one the commonest kind of trouble is that it is
nearly reasonable but not quite life is not an
illogicality yet it is a trap for logicians it looks just a little more
mathematical and regular than it is its exactitude is obvious but its
inexactitude is hidden its wildness lies in weight in other
words we know what's likely to happen we know the other things that
probably could happen instead we have little appreciation for the
things that are highly unlikely to happen but could and these are what we call in modern day terms the uh tail
events my friend Rick kanaine once said that 96% of financial history has
occurred within two standard deviations but everything interesting has happened outside of two standard deviations
that's the wild part [Music]
so now let me try in a slightly philosophical sense to reflect to you
how I think about risk how I think you might consider risk through four basic
points number one there was a professor at the London Business School who said
risk means more things can happen then will happen for most events that lie in
the future there are a number of things that could occur we don't know which one
it will be that's where the risk comes in more things can happen then will
happen number two as a result of that the future should be viewed not as a
fixed outcome that's destined to happen and capable of being predicted but as a range of possibilities and hopefully
because you have some insight into their respective likelihoods as a probability
distribution the most likely the less likely the unlikely but not impossible
number three it's important to accept that even when you know the
probabilities that doesn't mean you know what's going to happen uh this is uh something that I think many people fail
to grasp I play a lot of back gamon and a lot of my examples uh on risk and
uncertainty uh come from the game of back gamut which is played with a pair of dice and when you roll your pair of
dice we know exactly in advance what the probabilities are each die has six sides
there are 36 possible combinations of the six sides we know how many of them
for example will add up to seven and seven is the most likely single outcome
1 16 25 34 43 52 61 there are six
possibilities out of the 36 that will give you a seven that's the
most likely outcome uh six out of 36 that's 16.7% probability now what if
instead you want to know about a six well with a six there are five possibilities five possibilities out of
36 that's a little less than a seventh and then when you get down to uh the
number two is's only one one one one out of 36 and for the number 12 only one 66
one out of 36 both of those are about a 3% probability of happening so we know exactly what the probability
distribution looks like uh uh we know what's the most likely the other likely
possibilities and the unlikely possibilities we still don't know what's going to happen so knowing the
probabilities does not eliminate the uncertainty I work with a professor at Warden named Chris gsy and the way he
put it to me one time we live in the sample not the universe in other words
the universe statistics like I just explained for the dice determine the things that could happen
and maybe their possibility but we live in the sample we only have one outcome
and therein lies the uncertainty a great way to think about this is on Super Bowl
morning in 2016 they had a former football player on uh and he said what I
thought was one of the smartest things about uh probability I had ever heard
this game was Denver versus Carolina and Carolina was heavily favored and they asked him who he thought would win and
he said the following Carolina wins eight times out of 10 this could be one
of the two now this gives you the UN the essence of probability and the essence
of risk uh most people if they hear that something's 80% likely to happen they
say well then I guess we know what's going to happen I guess they might might as well not play the game no 80% likely
means that the other team should win one game out of five so have to play the game because we have to figure out which
game this will be and that leads to number four I take Dimson statement that
uh risk means more things can happen than will happen and I turn it over even though many things can happen
only one will thus the expected value the probability weighted average of the
possible outcomes which is the basis on which people make uh many decisions it
can be irrelevant they take each outcome they multiply it by the probability they
add them up and they get the expected outcome and many people will say well we're going to take the course of action
that has the highest expected value but sometimes the expected value isn't even
among the possibilities now this sounds highly counterintuitive but think about this let's consider a course of action
which has four possible outcomes 2 4 6 and 8 and let's say that we conclude
that each of those four is equally likely to happen so what we do is we
take each one 2 4 6 8 we multiply it by 25% the possibility of it happening and
we add it together and in this case the the expected value of 2 468 is five but
five can can't happen remember I said the outcomes can be 2 4 6 and eight so
it I'm I'm only going through this to show you the possible fallacy of expected value there's another problem
with expected value because even though course of action a can have a higher expected value than course of action B
course of action a may include some possibilities that you just can't live with maybe course of action a uh
includes some remote possibility that you lose all youry money and even though it's highly unlikely you you may say I
just don't want to contemplate that so you don't take a you take b instead which has a slightly lower expected
value uh but without the risk of
Ruin now moving on a little bit to to talk about the character of risk I think
it's interesting to note that risk is counterintuitive they did an experiment in the town of draon Holland they took
away all the traffic lights traffic signs and Road markings what do you think happened to the level of accidents
and fatalities it went down how could it possibly have gone down when all the
road AIDS were gone and the answer is people said oh there are no more traffic signs traffic lights or Road markings
I'd better drive more carefully on the other hand Jill fredson is uh an expert
on a avalanches and uh she said that better gear is created every year which
makes it easier and more feasible to to climb and yet the risk the number of
fatalities and accidents in Climbing doesn't go down how can that be obviously counterintuitive people see
that better gear is being invented and they say Well since we have better gear we can do riskier things and the level
of accidents and fatalities is maintained even in in spite of the arrival of better gear so if you think
about those two examples you realize that the risk of an activity doesn't just lie in the activity in itself but
importantly in how the participants approach it the degree of risk present
in a market or in an investment doesn't come just from the market or the investment
but how people participate in that investment and if they conclude that the
market has become safer they may say that that frees them to do riskier
things and that's why I believe that risk is low when investors behave
prudently and High when they don't just as risk is counterintuitive I believe
that risk is perverse as I said the riskiest thing in the world is the belief that there's there's no risk a
high level of risk Consciousness on the other hand tends to mitigate risk so when people say well that's really risky
if they take a a cautious approach then it becomes safe as an asset declines in
price most people say oh it's risky look how it's falling but with the lower
price it actually becomes less risky as an asset appreciates most people say that's a great asset look how well it's
doing but the rising price makes it riskier so again pervert
and this perversity is one of the main things that render most people incapable
of understanding risk I think it's important to grasp a concept risk is
hidden and risk is deceptive loss is what happens when risk the potential for
loss collides with negative events you know Buffett says everything the greatest and he said that uh it's only
when the tide goes out that we find out who's been swimming naked uh it's only in times of testing that
investors and their strategies uh are examined uh for the risk they really
held an example of that I wrote in my book The most important thing uh those
of us who live in California as I did at the time our houses might contain a
construction flaw but if all is well that flaw sits there for year after year
and doesn't produce any loss it's only when the earthquakes occur that the
house is tested and the flaws are disclosed and the risk the potential for
loss turns into actual loss so similarly an investment can be risky but if it
only exists in salutary environments it may look like a winter for a long time
and it may look safe for a long time the fact that an investment is susceptible to a risk that occurs extremely rarely
uh what I call an improbable disaster what Nasim Nicholas TB called The Black Swan in his excellent book The
infrequency of loss can make it appear that the investment is safer than it
really is and of course that's an entirely risky uh conclusion so uh the
infrequency with which uh risk turns into loss uh can be deceptive uh and
cause people to underrate the risk involved in an activ [Music]
one of the most important things for every investor to learn is that risk is not a function of asset quality this too
sounds counterintuitive there's a belief that high quality assets are safe and lowquality assets are risky I believe
quite the opposite a high quality asset can be priced so high that it's risky I
came to to work in this industry in September of 1969 the banks at that time
and I was hired by one of them engaged in what was called nifty50 investing
they invested in what were considered to be the 50 best and fastest growing companies in America companies so good
that nothing bad could ever happen and there was no price too high for their stocks and if you bought those great
companies the day I got to work in September of 1969 and if you held their stocks tenaciously for the next five
years you lost more than 90% of your money because the prices paid were just too high and unsustainable and roughly
half of those companies did run into serious fundamental problems their
quality alone or their perceive quality did not impart to them the safety that
people thought it would and in fact because people thought they were so safe they bid them up to prices which in fact
made them risky on the other hand a lowquality asset can be cheap enough to
be safe again this seems counterintuitive and maybe even perverse
when I left the world of equities in 1978 I was asked by City Bank to start
their activity in high yield bonds and now I was investing in the lowest
quality uh public companies in America and making money steadily and safely the
ju toos of these events taught me an important lesson uh that I want to share sh with you uh so that you don't have to
learn it firsthand my conclusion was it's not what you buy it's what you pay
and investment success doesn't come from buying good things but from buying things well and if you don't know the
difference you have to study up um there are no assets that are so good that they
can't become overpriced and dangerous there are very few assets that
are so bad that they can't be cheap enough to be attractive as Investments
so this is a a simple concept it sounds like to me but I hope you'll spend a lot
of time thinking about its [Music]
consequences now let's talk for a while about the relationship between risk and return this is one of the most important
of all the topics when I got to University of Chicago The Chicago School
of theory with regard to investment had just been developed mostly between 62
and 64 and I arrived in ' 67 and there was a graphic that we saw all the time
it shows uh return on the vertical axis risk on the horizontal axis and an
upward sloping line to the right we call that a positive correlation one goes up
the other goes up as well now most people would look at that graphic and say well that means two things that uh
riskier assets have higher returns and if you want to make more money the way to do it is to take more risk I think
that's a terrible formulation very simply if it were true that riskier assets produce higher returns then they
wouldn't be riskier would they so that can't be the right explanation what the upward sloping line
the positive correlation means is that Investments that are perceived as being
risky have to be perceived as offering higher returns to induce people to make
those Investments that makes perfect sense the only thing is they don't have to deliver and it's from the possibility
that the projected returns will not be delivered that the risk ensues when you
look at the old graph the linearity of the relationship between risk and return
implies a Dependable relationship and I've always felt that that was
misleading I was never happy uh when I got out into the real world and and and
had to live with the consequences and so I developed my own version of that chart
I took some little bell-shaped probability distributions and I turned them on their side and I superimpose
them on the same line it's the same underlying line just now with some embellishment with the old graph as you
moved from left to right the risk increased and the return increased but
with this new graft As you move from left to right the expected return increases just as it did in the old one
but at the same time the range of possibilities becomes wider and the worst outcomes become worse that's risk
this is the way to think about the risk return [Music]
relationship so now let's talk a little more about how risk should be handled
what determines investment success and the best way I have uh to communicate
this to you in my opinion is like the act of pulling one Lottery Ticket the
outcome from a bowl full of lottery tickets the full range of possible
outcomes as Dimson said we're going to have one outcome there could be many
outcomes and the outcome that occurs never amounts in my opinion to anything but one ticket pulled from
among the many in my opinion Superior investors have a better sense for the
tickets in the bowl for What proportion of them are winners and What proportion
of them are losers than do most other people that's what makes them Superior
and thus they have a better grasp of whether it's worth participating in a
any given Lottery and how heavily to bet now how should each of us deal with risk
I think that risk is best assessed through subjective judgment since risk cannot be measured gauging it has to be
the province of subject matter experts and I'm clearly uh jist on the subject
of quantification I believe imprecise qualitative expert opinion about the
probability of loss is far more useful than precise but
largely irrelevant numbers concerning past and projected volatility so what is
the essence of risk management Peter Bernstein again my my hero he said
because of the existence of risk things are going to be different from what we expect from time to time how well are we
prepared to deal when it's different this is a great formulation there's no
challenge dealing with the events when they turn out as we expected the
question is are we prepared for when they don't turn out as expected
according to Bernstein risk just means things are uncertain good things can happen as well as bad things but I think
the definition of risk should emphasize the bad things and thus I would say risk
is the possibility that from the range of Uncertain outcomes an unfavorable one
will be the one that materialize izes it can consist of suffering a permanent loss of capital when bad things happen
it can also consist of missing out on gains when good things happen these things have to be balanced let's say you
think that if you buy something today there's a one-third chance it'll be down in six or 12 months what will you do
about that risk many people will say well I just wouldn't buy it but what do you do about the other 2third the chance
that it'll be up in 6 to 12 months how do you balance the two risks and you know in the real world we can't make
decisions in one dimension we basically have to balance I think that risk is something that should be dealt with uh
constantly continuously not sporadically that's why I Bridal when I
hear this formulation is this a risk on Market or a risk off Market remember
risk produces loss when bad things happen and that's when we need risk control but I believe we never know when
bad things will happen and thus when risk control will be needed I think the
right model for thinking about whether we need risk control isn't American football is soccer in American football
the team with the ball has the offense on the field they have four tries to go 10 yards if they go 10 yards they get
four more tries to go 10 more yards and if they can keep doing it they eventually score but if the team doesn't
go 10 yards in four tries the referee Blows the Whistle the ball goes over to
to the other team and they try to go 10 yards in four tries in the opposite direction so we have two teams switching
between offense and defense changing Personnel when there are stoppages that
has nothing to do with the real world the right model as I say is what the
rest of the world calls football the same 11 people mostly play the whole
game nobody tells you when to be on offense or defense and there are very
few stoppages in which to adjust tactics and and Personnel that's the real world in
investing one of the key decisions is when to be on offense when to be on defense how much to allocate to each of
those but nobody tells you when to do it and nobody stops the game to give you time I think the best model for
investing and risk management is automobile insurance we all drive we all
have cars we all have insurance on our cars but I don't think of us get to the end of a year and say I wish I hadn't
had Insurance because I didn't have an accident we like having insurance for the safety it give us regardless of
whether or not we have an accident in a particular year I think about the intelligent bearing of risk for profit
back in 1981 I was interviewed by one of the first cable networks and uh the
reporter said to me how can you invest in high yield bonds when you know some of them are going to go bankrupt and for
some reason I was able to come up with the right answer on the spot I said the most conservative companies in America
are the life insurance companies how can they Ure people's lives when they know they're all going to die and I think
it's an interesting question but the life insurance company is number one taking a risk that it's aware of they're
not shocked when somebody dies that's the way it goes number two they take a risk they can analyze and when I was a
young man and got my first insurance policy they sent a doctor to my house to see if I was healthy number three they
take a risk that can be Diversified so no life insurance companies insure just
smokers or just people who live in on the San Andreas fault or just
skydivers just young people or just old people they have a mix a diversified portfolio and they take a risk that
they're well paid to Bear they figure out the probability of what they're going to have to pay you based on
Actuarial assumptions they allow some windage for the uncertainty and then they charge you a premium we do the same
we take credit risk that we're aware of we analyze it we take a risk that we can diversify we have large numbers of
Holdings in every portfolio which respond to different factors and it's a risk we're well paid to Bear we get
What's called the risk premium or a yield premium to take the risk of default so the bottom line is that I
believe risk is kept under control in Superior portfolios that's one of the things that Superior investors do highly
skilled investors assemble portfolio that will produce good returns if things go as expected and resist declines if
they don't this asymmetry is in my opinion the critical element the
Cornerstone of superior investing assembling a portfolio that incorporates risk control along with the potential
for gains is a great accomplishment but it's often a hidden accomplishment
because risk only turns into loss occasionally When the tide go goes out
but The Prudent investor and hopefully his or her clients knows that risk is
being controlled even at times when it doesn't come to the surface so I think
that risk is something to be managed and controlled but not avoided risk control
is indispensable risk avoidance is not an appropriate goal in investing Will
Rogers said you've got to go out on a limb sometimes because that's where the fruit is I think and my experience tells
me from watching others that risk avoidance equates to return
avoidance intelligent bearing of risk should be able to enable us to make good
returns with the risk under [Music]
control so what's the bottom line of all that
foregoing you shouldn't expect to make money without bearing risk you shouldn't expect to make money just for bearing
risk risk is best handled on the basis of accurate subjective judgments made by
experienced expert investors who emphasize risk Consciousness the great challenge in
investing is to limit uncertainty and still maintain substantial potential for
gains and in conclusion I'll just say that outstanding investors are out standing for the simple reason that they
have a superior sense for the probability distribution that governs future events
the tickets in the bowl and for whether the potential return compensates for the
risks that lurk in the distribution's unattractive left-and tail this is what
enables them to achieve the asymmetry that characterizes Superior investors
participating strongly in the game GS when there are gains and avoiding many of the losses when there are losses