Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk”

No commentary necessary – self explanatory and eloquently written.

Definition of Investing, Risk

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

Risk, Process Over Outcome, Luck

“Many futures are possible…but only one future occurs…Many things could have happened in each case in the past, and fact that only one did happen understates the variability that existed.”

“In the investing world, one can live for years off one great coup or one extreme but eventually accurate forecast. But what’s proved by one success? When markets are booming, the best results often go to those who take the most risk. Were they smart to anticipate good times and bulk up on beta, or just congenitally aggressive types who were bailed out by events? Most simply put, how often in our business are people right for the wrong reasons? These are the people Nassim Nicholas Taleb calls ‘lucky idiots,’ and in the short run it’s certainly hard to tell them from skilled investors.

The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed. Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa. With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)? And ditto for a loser: how do we ascertain whether it was a reasonable but ill-fated venture, or just a wild stab that deserved to be punished?

Did the investor do a good job of assessing the risk entailed? That’s another good question that’s hard to answer. Need a model? Think of the weatherman. He says there’s a 70 percent chance of rain tomorrow. It rains; was he right or wrong? Or it doesn’t rain; was he right or wrong? It’s impossible to assess the accuracy of probability estimates other than 0 and 100 except over a very large number of trials.”