Howard Marks' Book: Chapter 6 - Part 2


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” Marks does a fantastic job illustrating the impact of the (low) risk free rate on portfolio expected risk & return, position selectivity, hurdle rate & opportunity cost.

Expected Return, Hurdle Rate, Opportunity Cost, Risk Free Rate, Selectivity

“The investment thought process is a chain in which each investment sets the requirement for the next…The interest rate on the thirty-day T-bill might have been 4 percent. So investors, says, ‘If I’m going to go out five years, I want 5 percent. And to buy the ten-year note I have to get 6 percent.’ Investors demand a higher rate to extend maturity because they’re concerned about the risk to purchasing power, a risk that is assumed to increase with time to maturity. That’s why the yield curve, which in reality is a portion of the capital markets line, normally slopes upward with the increase in asset life.

Now let’s factor in credit risk. ‘If the ten-year Treasury pays 6 percent, I’m not going to buy a ten-year single-A corporate unless I’m promised 7 percent.’ This introduces the concept of credit spread. Our hypothetical investor wants 100 basis points to go from a ‘guvvie’ to a ‘corporate’…

What if we depart from investment-grade bonds? ‘I’m not going to touch a high yield bond unless I get 600 over a Treasury note of comparable maturity.’ So high yield bonds are required to yield 12 percent, for a spread of 6 percent over the [ten-year] Treasury note, if they’re going to attract buyers.

Now let’s leave fixed income altogether. Things get tougher, because you can’t look anywhere to find the prospective return on investments like stocks (that’s because, simply put, their returns are conjectural, not ‘fixed’). But investors have a sense for these things. ‘Historically S&P stocks have returned 10 percent, and I’ll buy them only if I think they’re going to keep doing so…And riskier stocks should return more; I won’t buy on the NASDAQ unless I think I’m going to get 13 percent.’

From there it’s onward and upward. ‘If I can get 10 percent from stocks, I need 15 percent to accept the illiquidity and uncertainty associated with real estate. And 25 percent if I’m going to invest in buyouts…and 30 percent to induce me to go for venture capital, with its low success ratio.’

That’s the way it’s supposed to work…a big problem for investment returns today stems from the starting point for this process: The riskless rate isn’t 4 percent; it’s close to 1 percent…Typical investors still want more return if they’re going to accept time risk, but with the starting point at 1+ percent, now 4 percent is the right rate for the ten-year (not 6 percent)…and so on. Thus, we now have a capital market line…which is (a) at a much lower level and (b) much flatter.”

“…each investment has to compete with others for capital, but this year, due to low interest rates, the bar for each successively riskier investment has been set lower than at any time in my career.” Most investors have, at some point, gone through a similar thought process:

  • Should I make this investment?
  • What is the minimum return that will compel me to invest? (For discussion purposes, we’ll call this the Hurdle Rate.)
  • How do I determine my hurdle rate?

Based on the quotes above, the hurdle rate is determined based upon a mixture of considerations including: (1) the risk-free rate (2) the expected return of other available investments or asset classes, and (3) perhaps a measure of opportunity cost (for which the calculation opens a whole new can of worms).

In essence, this is a selectivity exercise, comparing the expected returns between possible investment candidates along the “risk” spectrum. After all, “each investment has to compete with others for capital” because we can’t invest in everything.

Howard Marks highlights a problematic phenomenon of recent days: the declining risk-free-rate pushing down the starting point for this exercise, and consequently the entire minimum return requirement (hurdle rate) curve for investors.

So the following questions emerge:

  • Is your minimum return requirement (hurdle rate) curve relative or absolute vs. the crowd?
  • If relative, do you join the crowd and lower your minimum return hurdle rate?
  • Just a little, you say? Is there a point at which you draw the proverbial line in the sand and say “no further” because everyone has lost their minds?
  • Do you then go to cash? Is there any another alternative? Are you prepared to miss out on potential returns (as other investors continue to decrease their hurdle rates and chase assets/investments driving prices even higher)?

Wait, this sounds very familiar. Remember our Part 1 discussion on “risk manifestation” due to irrational market participant behavior and high asset prices?

Risk, Expected Return

“…the herd is wrong about risk at least as often as it is about return.”

We have often discussed the concept of expected return (a forward looking prediction on future return outcome), but we have been remiss in discussing the concept of expected risk (a forward looking prediction on future risk outcome).

Misguided predictions of either expected return or expected risk have the potential to torpedo investment theses.