How to Think About Risk - Lecture by Howard Marks

Introduction

• Title: How to Think About Risk
  • Focus on "how" to think, not "what" to think about risk.
• Risk as a Measure of Skill:
  • Risk is the ultimate test of an investor's skill.
  • Return alone doesn't indicate performance; consider the risk taken to get the return.

Evaluating Managers

• Manager Performance:
  • Managers showing market-like returns (up 10%, down 10%) add no value.
  • Overly aggressive managers (up 20%, down 20%) show no skill.
  • Defensive managers (up 5%, down 5%) are equally ineffective.
  • Value-Added Manager:
    • Gains more in good times, loses market-equivalent in bad times.
    • Asymmetry: Better upside performance, controlled downside losses.

Understanding Risk

• Risk vs. Volatility:
  • Risk is not volatility; volatility is merely an indicator.
  • Risk is the probability of loss.
  • Risk is not quantifiable in advance or even post-event.

Various Forms of Risk

• Types of Risk:
  • Risk is multi-dimensional; includes missing opportunities, taking insufficient risk, etc.
  • Key risk: Being forced to sell at the bottom.

Philosophical Insights on Risk

• Quotations:
  • Peter Bernstein: "Risk says we don't know what's going to happen."
  • G.K. Chesterton: "Life is a trap for logicians."
  • Rick Kane: Interesting events occur outside common statistical deviations.

Key Concepts of Risk

1. Multiple Outcomes Possible: More things can happen than will.
2. Future as a Range: Not a fixed outcome; requires probability distribution.
3. Probabilities don't assure outcomes: Knowing probabilities doesn't eliminate uncertainty.
4. Expected Value Fallacy: Expected value can be irrelevant; doesn't account for outcomes you can't live with.

Risk in Practice

• Counterintuitive Risk:
  • Risk perception affects behavior.
  • High caution reduces risk, complacency increases it.
• Risk is Hidden and Deceptive:
  • Loss occurs when risk collides with negative events.
  • Risk isn't fully revealed until tested (e.g., during economic downturns).

Asset Quality and Risk

• Risk is Not Asset Quality:
  • High-quality assets can be risky if overpriced.
  • Low-quality assets can be safe if priced attractively.
  • Success is buying things well, not just buying good things.

Risk and Return Relationship

• Chicago School Theory:
  • Positive correlation between perceived risk and expected returns.
  • Riskier assets perceived to offer higher returns but don't always deliver.

Handling Risk

• Investment Success:
  • Superior investors understand the range of potential outcomes better.
• Subjective Judgment:
  • Risk assessment should be qualitative and based on expert opinions.

Risk Management

• Philosophy:
  • Be prepared for unexpected outcomes.
  • Balance risks of losing capital and missing gains.
  • Continuous risk management required.
• Analogies:
  • Soccer for continuous play (offense and defense simultaneously).
  • Automobile insurance for ongoing risk coverage.

Conclusion

• Intelligent Risk Bearing:
  • Important to bear risk for profit without avoiding it entirely.
  • Risk control is crucial; risk avoidance leads to missed opportunities.
• Outstanding Investors:
  • Have a superior sense of probability distribution of future events.
  • Achieve asymmetry: Participate in gains, avoid many losses.