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Rethinking the Concept of Risk in Investments

You can’t do the same things others do and expect to outperform. The most dependable way to outperform the market is to buy something for less than its value. It is price, not quality, that determines value: high-quality assets can be risky, and low quality assets can be safe.

Howard S. 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.

Investing, by its very nature, is fraught with risk. Howard Marks, in his insightful book "The Most Important Thing," delves into understanding and managing this inherent risk, providing valuable lessons for investors of all stripes.

💡 Howard Marks on investing ▶️

A few takeaways from the book are a potent reminder that risk isn't always a deterrent but can be transformed into an opportunity with the right tools and mindset.

The capital market line is misleading

You may have come across the capital market line displayed below. Its purpose is to illustrate the relationship between an investor’s expected return and the level of risk associated with their investment. However, this line can give the impression that the only way to increase returns is by taking on more risk. This is not entirely true, as investments with higher risk do not always guarantee higher returns. If they did, they would not be considered risky.

The proper statement is that riskier investments must offer the possibility of greater returns to entice investment. However, it is important to note that these potential returns may not actually come to fruition.

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 an investment is priced fairly, it may involve some risks, which include:

- The potential for higher returns

- The possibility of lower returns

- In certain situations, the possibility of incurring losses.

Academics define risk incorrectly

Academics commonly refer to risk as volatility, also known as beta. However, Marks disagrees with this measure of risk and finds it inappropriate.

According to Howard Marks, he has never heard anyone, either at Oaktree or elsewhere, express hesitation in purchasing a product due to potential price fluctuations or the possibility of a down quarter.

People are concerned about the possibility of losing their capital or receiving a low return, which is a risk they are worried about.

The cause of risk is not always weak fundamentals

Even assets that are considered weak, such as stocks of companies with poor performance, low-grade bonds, or properties located in unfavorable areas, can become profitable investments if purchased at a significantly discounted price.

Risk is subjective

When it comes to investing, people have different perceptions of risk. Some may view it as the likelihood of not earning a profit, while others may see it as the possibility of losing a certain percentage of their investment. Additionally, some may consider the risk of losing money within a year, while others may consider it over the entire duration of their investment.

Risk is caused by the price paid

The main source of investment risk is overpriced assets which are typically a result of excessive optimism, insufficient skepticism, and risk aversion.

When a consensus forms that something is risky, people tend to avoid buying it, which can cause its price to drop to a level where it is actually not very risky. Conversely, when people view something as low-risk, they may bid its price up to a point where it becomes highly risky.

This paradox arises from the common belief among investors that an asset's quality determines its level of risk rather than its price. However, high-quality assets may carry risk, while low-quality assets may be safe, depending on the price paid for them.

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

Achieving a return that is equal but with lower risk can be just as impressive as a higher return with equal risk.

Some experts argue that inefficient markets have an advantage in that a manager can assume the same level of risk as the benchmark but still attain a higher rate of return. However, this is only one aspect of the matter. In an efficient market, a proficient investor can obtain the same return as the benchmark while accepting less risk.

Sometimes, it can be challenging to determine the level of risk associated with an investment, and unfortunately, the true extent of the risk may only become apparent after a big event.

Risk is often concealed and can go unnoticed until a negative event transpires, leading to an evident loss. It is crucial to acknowledge that even though the chance of loss may not be apparent, the impact of risk is genuinely substantial.

Risk is the possibility of things going wrong. Loss only occurs when things don't go as planned.

As investors, we should not fear #risk but we should remain mindful of its presence. While it's important to welcome risk, we should do so only when the expected return is reasonable, and the price is right. While #investing in AAA Government bonds may eliminate all risks, it would also mean forgoing any returns above the risk-free rate. As intelligent #investors we should instead aim for risk control rather than avoidance.


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