Howard Marks' Book: Chapter 6 - Part 1


Continuation of portfolio management highlights from Howard Marks’ book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, Chapter 6 “The Most Important Thing Is…Recognizing Risk” Risk, Intrinsic Value, Psychology

“Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.”

“It’s also ephemeral and unmeasurable. All this makes it very hard to recognize, especially when emotions are running high. But recognize it we must.”

“…the theorist thinks return and risk are two separate things, albeit correlated, the value investors thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices. Thus, awareness of the relationship between price and value – whether for a single security or an entire market – is an essential component of dealing successfully with risk….Dealing with this risk starts with recognizing it.”

“High risk, in other words, comes primarily with high prices.”

“…the degree of risk present in a market derives from the behavior of the participants, not from securities, strategies and institutions.”

“The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it. Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the ‘perversity of risk.’”

“No matter how good fundamentals may be, humans exercising their greed and propensity to err have the ability to screw things up.” As Marks points out, there exists an unbreakable relationship between the purchase price (relative to the intrinsic value) of an investment, and the level of risk within an investment. In other words, a portion of the risk of any investment is price dependent.

But price is a moving target, nudged around by the actions of market participants. Therefore, there’s also a link between the behavior of market participants and the manifestation of risk.

So the curious bug wonders, is the existence of risk absolute? Or does it only emerge under certain circumstances, such as when market participants drive asset prices sky high? Marks calls the latter the “perversity of risk” – a monster of our own creation.

If risk does manifest only at certain times due to market participant behavior, then in order to recognize risk, we must keep an acute awareness of not only our own actions, but also our surroundings and the actions of other market participants (as it relates to price vs. intrinsic value).