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” This is the first of three chapters to which Howard Marks dedicates to the topic of Risk. For those interested in Marks' thoughts on risk, these chapters are absolute must-reads.
Topics covered in this installment: Risk, Volatility
“According to the academicians who developed capital market theory, risk equal volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition. It is my view that…academicians settled on volatility as the proxy for risk as a matter of convenience. They needed a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risk do not. The problem with all of this, however, is that I just don’t think volatility is the risk most investors care about…I’ve never heard anyone at Oaktree – or anywhere else, for that matter – say, ‘I won’t buy it, because its price might show big fluctuations,’ or ‘I won’t buy it, because it might have a down quarter.’…To me, ‘I need more upside potential because I’m afraid I could lose money’ makes an awful lot more sense than ‘I need more upside potential because I’m afraid the price may fluctuate.’”
To be fair, Oaktree and most private equity investors have semi-permanent long-term capital (thanks to the lock-up terms). Most public market fund managers do not have this luxury, and are more vulnerable to the vagaries of short-term volatility that can lead to other types of risks such as “underperformance risk” and “career risk” (Marks discusses both later on). The public market fund managers themselves may not fear volatility, but in the instance the underlying client base loses patience and demands the return of capital via redemptions, volatility becomes a very real risk in the form of permanent impairment of capital.
“…hopefully we can agree that losing money is the risk people care about most…An important question remains: how do they measure that risk? First, it clearly is…a matter of opinion: hopefully an educated, skillful estimate of the future, but still just an estimate. Second, the standard for quantification is nonexistent. With any given investment, some people will think the risk of high and others will think it is low.”
“…risk and the risk/return decision aren’t ‘machinable,’ or capable of being turned over to a computer…Ben Graham and David Dodd put it this way more than sixty years ago…‘the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulations.’”
“The bottom line is that, looked at prospectively, much of risk is subjective, hidden, and unquantifiable. Where does that leave us? If the risk of loss can’t be measured, quantified or even observed – and if it’s consigned to subjectivity – how can it be dealt with? Skillful investors can get a sense for the risk present in a given situation…There have been many efforts of late to make risk assessment more scientific. Financial institutions routinely employ quantitative “risk managers” separate from their asset management teams and have adopted computer models such as “value at risk” to measure the risk in a portfolio…In my opinion, they’ll never be as good as the best investors’ subjective judgment.”
Qualitative vs. Quantitative. Both worthy adversaries, each camp with its prolific heroes.
It’s likely that successful quantitative investors (such as David E. Shaw who utilize computerized risk optimizers) would disagree with Marks’ statement above, that risk management entails more art than science. But the secretive nature of their algorithms and risk models make it difficult to comprehend how the successful quants are able to quantify risk via “machinable” methodologies contrary to the opinions of Howard Marks, Ben Graham, and David Dodd.