I’m finally back from vacation. In light of recent market volatility and “risk,” let’s kick off with a 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”

Risk, Intrinsic Value

“…risk of loss does not necessarily stem from 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.”

“Theory says high return is associated with high risk because the former exists to compensate for the latter. But pragmatic value investors feel just the opposite: they believe high return and low risk can be achieved simultaneously by buying things for less than they’re worth. In the same way, overpaying implies both low return and high risk.”

There exists an unbreakable relationship between the purchase price (relative to the intrinsic value) of an investment, and the inherent risk of that investment. In other words, a portion of the risk of any asset is price dependent.

Risk

Howard Marks highlights a few other types of risk, beyond is usual loss of capital, etc. Investment risk can take on many other forms – personal and subjective – varying from person, mandate, and circumstance.

“Falling short of one’s goal – …a retired executive may need 4 percent…But for a pension fund that has to average 8% per year, a prolonged period returning 6 percent would entail serious risk. Obviously this risk is personal and subjective, as opposed to absolute and objective…Thus this cannot be the risk for which ‘the market’ demands compensation in the form of higher prospective returns.”

“Underperformance – …since no approach will work all the time – the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up. (See Warren Buffett and Julian Robertson in 1999.)”

“Career Risk – …the extreme form of underperformance risk…risk that could jeopardize return to an agent’s firing point…”

“Unconventionality – …the risk of being different. Stewards of other people’s money can be more comfortable turning in average performance, regardless of where it stands in absolute terms, than with the possibility that unconventional actions will prove unsuccessful and get them fired.”

“Illiquidity – …being unable when needed to turn an investment into cash at a reasonable price.”

Theory suggests that asset returns compensate for higher “risk.” If this is true, how then do assets compensate for subjective risks that vary from person to person, such as falling short of one’s return goal, or career risk stemming from unconventionality?

This highlights the necessity for portfolio managers to identify and segment risks – objective or subjective & quantitative or qualitative – before implementing risk management or hedging strategies.

Risk, Fat Tail

“‘There’s a big difference between probability and outcome. Probable things fail to happen – and improbable things happen – all the time.’ That’s one of the most important things you can know about investment risk.”

“The fact that an investment is susceptible to a particularly serious risk that will occur infrequently if at all – what I call the improbable disaster – means it can seem safer than it really is.”

“…people often use the terms bell-shaped and normal interchangeably, and they’re not the same…the normal distribution assumes events in the distant tails will happen extremely infrequently, while the distribution of financial developments – shaped by humans, with tendency to go to emotion-driven extremes of behavior – should probably be seen as having ‘fatter’ tails…Now that investing has become so reliant on higher math, we have to be on the lookout for occasions when people wrongly apply simplifying assumptions to a complex world.”