How investors should understand risk
Elena Chirkova
Oct 11, 2024Famous investor Howard Marks, founder of Oaktree Capital, recently in a series of videos explained, how investors should approach risk. Marks is the author of a well-known book on market cycles, in which he examined, among other things, the psychological aspects of market ups and downs. Warren Buffett once said: "When I see letters from Howard Marks in my mail, they are the first thing I open and read." Marks' quotes on the nature of risk, highlighted in italics, are commented on by Elena Chirkova, senior partner at Movchan’s Group and advisor to the GEIST fund.
Risk and volatility are not synonyms
Risk is the probability of losses. Volatility can only be a symptom of risk
It all depends on the investor's time horizon. Volatility is not important if the horizon is very long, because an upward trend will offset it. For such an investor, the risk lies in not understanding the essence of the asset, not in its volatility. Warren Buffett spoke about this. However, if you might need the money tomorrow and are forced to sell the asset, then volatility is a factor for you.
Asymmetry is a key point for investors
Asymmetry is the ability to achieve profits during market upswings and minimize losses during downturns
I think this statement is true for an investor who only opens long positions. Because a falling market can wipe out even some brilliant undervalued stocks that should theoretically rise. It's not necessarily so. There are many hedge funds in the world that profit from declines. They open short positions, which may even outweigh long ones in the portfolio. In this case, the fund is more at risk when the market is rising. Its positions are going against the current, so to speak.
Risk cannot be quantitatively assessed
Investors have to rely on their own risk assessments, not just historical data
Risk in terms of volatility can be quantitatively assessed. It can be measured by parameters such as standard deviation, beta, and maximum drawdown, and all of them are countable. Where Marks is right is that there are no guarantees that the fate of an asset will not change, and one can only rely on historical data. In some market segments, there is elementary cyclicality. Worse, there are assets that can lose their value in principle if the goods or services the company produces become unneeded.
There are many forms of risk
Not only losses but also missed growth potential, including due to taking too little risk
No, let's be honest. Not all losses, including missed opportunities, should be attributed to risk. These are losses of a different nature — from the investor's unwillingness to take on risk. Risk tolerance is a matter of psychology, not finance. An investor has every right not to like it.
Risk arises from the inability to predict the future
'Tail events' — rare and extreme phenomena — can have an excessive impact on a portfolio
I fully agree with the first thesis. And with the second one too, but with a caveat. Most 'tail events' are not predictable in the sense that we don't know when they will happen, but we know they can happen. As Warren Buffett says, it's easier to predict what will happen than when it will happen.
Counterintuitiveness of risk
When markets seem safe, investors tend to take on more risk
This is a paraphrase of a famous quote from Warren Buffett, which, however, is in the imperative mood: 'Be fearful when others are greedy, and greedy when others are fearful.'
Risk does not depend on asset quality
High-quality assets can become risky if their prices rise to an unacceptable level
This is also borrowed from Warren Buffett, who said that risk comes from the investor not understanding what they are investing in (and we mentioned this above) and from buying at an inflated price. It's worse to buy an expensive asset with low volatility than a cheap one with high volatility, I'll add from myself.
Risk and return do not always correlate
Taking on more risk does not always lead to increased profits
This is certainly true. Even financial market theory postulates that only undiversified risk is rewarded. The phrase 'higher risk — higher return' should be understood in reverse: the issuer of a security/project owner must offer the investor increased compensation for increased risk. This does not mean that taking on higher risk will necessarily be better rewarded. Deviations are possible, and even an experienced investor who can correctly assess the risk/return ratio may lose money without proper diversification, as anything can happen with a single asset.
Risk is inevitable
The main thing is not to avoid risk, but to manage it wisely and control it
How can one not recall the joke about the wise owl, to whom the little hare came for a consultation. Everyone in the forest bullied him, and she advised him to become a hedgehog.
Why know this
Proper understanding of risk protects the investor from wrong investments.
