Howard Marks' Book: Chapter 5 - Part 2

The following excerpt from Howard Marks' book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 5 “The Most Important Thing Is…Understanding Risk,” is one of the best clarifications on the relationship between risk and return that I have ever read. Risk, Expected Return

“…when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return…Clearly, return tells just half of the story, and risk assessment is required.”

“…‘capital markets line’ that slopes upward to the right, indicating the positive relationship between risk and return…the familiar graph…is elegant in its simplicity. Unfortunately, many have drawn from it an erroneous conclusion…if riskier investments reliable produced higher returns, they wouldn’t be riskier! The correct formulation is that in order to attract capital, riskier investments have to offer the prospect of higher returns, or higher promised returns, or higher expected returns. But there’s absolutely nothing to say those higher prospective returns have to materialize.”

“Riskier investments are those for which the outcome is less certain. That is, the probability distribution of return is wider…The traditional risk/return graph is deceptive because it communicates the positive connection between risk and return but fails to suggest the uncertainty involved. It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money. I hope my version of the graph [see above] is more helpful. It’s meant to suggest both the positive relationship between risk and expected return and the fact that uncertainty about the return and the possibility of loss increase as risk increases.”