Howard Marks on Risk and Investing: How to Think About Risk

1. What is Risk?
According to Howard Marks, risk is the ultimate test of an investor's skill. It's not just about returns; the key question is how much risk was taken to achieve those returns. Marks emphasizes that simply achieving market-level returns isn't enough; true skill is demonstrated when an investor can outperform without taking excessive risk.

He discusses various hypothetical investment managers, illustrating that aggressive investing (gaining or losing twice the market rate) or overly defensive strategies do not reflect value-added skill. The ideal scenario is a manager who outperforms when the market rises and mitigates losses when the market falls.

2. Risk is Not Volatility
Marks rejects the idea that volatility is a measure of risk, despite it being widely used by academics. He argues that volatility is just an indicator or symptom of risk, but not risk itself.

In Marks' view, risk is the probability of loss. Investors should focus on avoiding losses rather than worrying about volatility. Risk is often about the possibility of permanent capital loss, which is more significant than short-term fluctuations.

3. Risk is Unquantifiable in Advance
Marks emphasizes that risk is a matter of opinion, not something that can be measured or quantified precisely in advance. Even after the fact, it can be hard to tell if an investment was risky simply based on its outcome. A profitable investment might still have been risky, but the risk just didn’t materialize.

He points out that risk involves not only the potential for loss but also the missed opportunities from taking too little risk. Moreover, the greatest risk often comes from the illusion of safety, when people think an investment is risk-free because of past performance.

4. The Perception of Risk and Tail Events
Marks reflects on how risk is hidden and deceptive. Investors can be lulled into thinking an investment is safe if it hasn’t experienced loss for a long time, but unforeseen events can trigger substantial losses. These are often called "tail events"—rare, unpredictable occurrences that can have outsized impacts, as described by Nassim Taleb in his book The Black Swan.

The risk of missing out on opportunities by avoiding investments due to fear of loss is just as dangerous as taking on too much risk. Marks stresses the importance of finding the right balance between these two extremes.

5. Risk and Asset Quality
Marks challenges the conventional belief that high-quality assets are automatically safe and low-quality assets are inherently risky. He illustrates that high-quality assets can be risky if they are overpriced, while low-quality assets can be safe if they are bought at the right price. It’s not the asset’s quality alone that matters, but what you pay for it.

He provides an example from the late 1960s when investors paid too much for the "nifty fifty" stocks (the top 50 companies), which led to huge losses despite the companies being considered high-quality.

6. The Relationship Between Risk and Return
Marks criticizes the simplistic view that higher risk automatically leads to higher returns. He argues that risky assets are perceived to offer higher returns to entice investors, but they don’t always deliver on that promise. It’s the possibility that expected returns won’t materialize that creates risk.

He presents a more nuanced view of the risk-return relationship, where as you move toward riskier investments, the range of possible outcomes widens, and the worst outcomes become worse. Therefore, taking more risk doesn’t guarantee higher returns; it merely increases the spread of potential results, both good and bad.

7. Risk Management and Control
Risk control is essential to long-term investing success. Marks stresses that risk should be managed and controlled, but not completely avoided. The goal is to intelligently bear risk while making sure the risk is compensated for by the potential for gain.

He compares risk management to automobile insurance, where people pay for protection regardless of whether an accident occurs. Investors should always aim to manage risk, even when markets seem stable, because risk events can occur unexpectedly.

8. Outstanding Investors and Asymmetry
Marks concludes that outstanding investors have a better sense of the probability distribution of future outcomes. They aim to achieve asymmetry, meaning they participate in gains when the market performs well and minimize losses when it performs poorly. This asymmetry is what distinguishes superior investors from the rest.

He emphasizes the need for constant risk control, not just during market downturns, but all the time, because investors never know when risk will materialize.

Conclusion:
1. Risk as a Core Component of Investing

Howard Marks' approach to risk highlights a critical component of successful investing—understanding and managing risk effectively. His rejection of volatility as the sole indicator of risk is insightful, as real-world investing involves assessing long-term risks like permanent capital loss rather than worrying about short-term market swings.

Marks' idea that risk is unquantifiable aligns with the real-world uncertainty that investors face. No formula can predict with certainty how investments will perform, and understanding this uncertainty is key to making informed decisions.

2. The Balance Between Risk and Opportunity

One of the key takeaways from Marks is the balance between avoiding losses and not missing out on opportunities. This resonates strongly with modern-day investment dilemmas, such as whether to invest in high-growth tech stocks that might be overvalued but offer significant upside.

Marks' advice that risk increases with overconfidence (when investors assume safety) is a valuable lesson. This was particularly evident during the dot-com bubble and the housing market crash, where perceived safety led to risky behavior.

3. Investing with Asymmetry

Marks’ concept of asymmetry is central to value investing and long-term success. Investors should aim to maximize their participation in market gains while minimizing exposure to losses. This strategy reflects the approach taken by Warren Buffett, who also focuses on minimizing downside risk while capitalizing on market opportunities.