Howard Marks new memo enjoy!

In April I had good results with Dare to Be Great II, starting from the base established in an earlier memo (Dare to Be Great, September 2006) and adding new thoughts that had occurred to me in the intervening years. Also in 2006 I wrote Risk, my first memo devoted entirely to this key subject. My thinking continued to develop, causing me to dedicate three chapters to risk among the twenty in my book The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor. This memo adds to what I’vepreviously written on the topic.


What Risk Really Means


In the 2006 memo and in the book, I argued against theMANAGEMENT,purported identity between volatility and risk.

Volatility is the academic’s choice for defining and measuring risk.  I think this is the case largely

because volatility is quantifiable and thus usable in the calculations and.models of modern finance theory.

In the book I called it “machinable,” and there is no substituteRESERVEDforthepurposes of the calculations. However, while volatility is quantifiable and machinable – and can also be an indicator or symptom of

riskiness and even a specific form of risk – I think it falls far short as “the” definition of investment risk.

In thinking about risk, we want to identify the thing that investors worry about and thus demand






compensation for bearing.  I don’t thinkCAPITALmost investors fear volatility.  In fact, I’ve never heard anyone


say, “The prospective return isn’t high enoughRIGHTSto warrant bearing all that volatility.”  What they fear is


Permanent loss is very different from volatility or fluctuation. A downward fluctuation – which by definition is temporaryOAKTREE–doesn’tpresent ALLa big problem if the investor is able to hold on and come out the other side. A permanent loss – from which there won’t be a rebound – can occur for either of two


reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing – whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but©we never get a chance to undo a permanent loss.


Of course, the problem with defining risk as the possibility of permanent loss is that it lacks the very thing volatility offers: quantifiability. The probability of loss is no more measurable than the probability of rain. It can be modeled, and it can be estimated (and by experts pretty well), but it cannot be known.


In Dare to Be Great II, I described the time I spent advising a sovereign wealth fund about how to organize for the next thirty years. My presentation was built significantly around my conviction that risk can’t be quantified a priori. Another of their advisors, a professor from a business school north of New York, insisted it can. This is something I prefer not to debate, especially with people who’re sure they have the answer but haven’t bet much money on it.


One of the things the professor was sure could be quantified was the maximum a portfolio could fall under adverse circumstances. But how can this be so if we don’t know how adverse circumstances can be


Even a Probability Distribution Isn’t Enough


I’ve stressed the importance of viewing the future as a probability distribution rather than a single predetermined outcome. It’s still essential to bear in mind key point number threeP.: Knowing the probabilities doesn’t mean you know what’s going to happen. For example,L.every good backgammon


player knows the probabilities governing throws of the dice. They know there are 36 possible outcomes, and that six of them add up to the number seven (1-6,MANAGEMENT,2-5,3-4,4-3,5-2and6-1). Thus the chance of throwing a seven on any toss is 6 in 36, or 16.7%. There’s absolutely no doubt about that. But even

though we know the probability of each number, we’re far from knowing what number will come up on a

given roll.                                                                                                     .

Backgammon players are usually quite happy to make aRESERVEDmovethatwillenable them to win unless the opponent rolls twelve, since only one combination of the dice will produce it: 6-6. The probability of

rolling twelve is thus only 1 in 36, or less than 3%. But twelve does come up from time to time, and the people it turns into losers end up complainingCAPITALabout having done the “right” thing but lost. As my friend Bruce Newberg says, “There’s a big differenceRIGHTSbetween probability and outcome.” Unlikely things


happen – and likely things fail to happen – all the time. Probabilities are likelihoods and very far from certainties.


It’s true with dice, and OAKTREEit’strueininvesting . . . and not a bad start toward conveying the essence of risk. Think again about the quote above fromALLElroy Dimson: “Risk means more things can happen than will

happen.”  I find it particularly helpful to invert Dimson’s observation for key point number four:


Even though many things can happen, only one will.


In Dare to Be Great©II, I discussed the fact that economic decisions are usually best made on the basis of “expected value”: you multiply each potential outcome by its probability, sum the results, and select the path with the highest total. But while expected value weights all of the possible outcomes on the basis of their likelihood, there may be some individual outcomes that absolutely cannot be tolerated. Even though many things can happen, only one will . . . and if something unacceptable can happen on the path with the highest expected value, we may not be able to choose on that basis. We may have to shun that path in order to avoid the extreme negative outcome. I always say I have no interest in being a skydiver who’s successful 95% of the time.


Investment performance (like life in general) is a lot like choosing a lottery winner by pulling one ticket from a bowlful. The process through which the winning ticket is chosen can be influenced byphysical processes, and also by randomness. But it never amounts to anything but one ticket picked from among many. Superior investors have a better sense for the tickets in the bowl, and thus for whether it’s worth buying a ticket in a lottery. Lesser investors have less of a sense for the probabilitydistribution and for whether the likelihood of winning the prize compensates for the risk that the cost of the ticket will be lost.

Howard Marks
Howard Marks