Howard Marks, Chairman of Oaktree Capital Management, appeared on Bloomberg TV’s “Market Makers” with Erik Schatzker and Stephanie Ruhle today, where he spoke about his new memo and the current market rally, saying “we’re between the bottom of the seventh and the top of the eighth.” Marks said, “It’s time for the seventh inning stretch. I think you have to have plenty of defense on the field today. And most people are sitting on a lead, and when you have a lead you send in the defense specialists.”
Marks said that “every investor faces two risks” and “…the question is which should you worry about more today, losing money or missing opportunity? I’d put some more emphasis on worrying about losing money today than I do about missing opportunities because I don’t see such great opportunities that I have to worry about.”
Howard Marks on Risk Assessment, Market Strategy
STEPHANIE RUHLE: Surely you’ve heard this line before. If you want to make more money investing, take more risk. Fine. Great even, if you understand what risk actually means. Howard Marks says most people don’t, and he should know. He’s the chairman of Oaktree Capital Group LLC (NYSE:OAK) and one of the greatest investors in distressed debt. Howard, welcome back. Your newest letter is out. Tell us, what don’t people understand?
HOWARD MARKS, CHAIRMAN, OAKTREE CAPITAL MANAGEMENT: The main thing people don’t understand is that it’s wrong to say if you want to make more money, take more risk. This is what people say. Higher — riskier — riskier investments have higher returns. So if you want to make more money, take more risk. It can’t be right, Stephanie.
HOWARD MARKS: Because if riskier could be counted on to produce higher returns, they wouldn’t be riskier. It’s at simple as that. There’s got to be something wrong with that formation. What we should say is that investments that appear riskier have to appear to offer higher returns or nobody will make them. But that doesn’t mean it has to come true. And lots of things other — lots of things can happen other than what you hope will happen.
ERIK SCHATZKER: Is it also true that investing in riskier instruments increases your chances of higher returns but also of higher losses?
HOWARD MARKS: Exactly, exactly. That’s — that’s the thing that people have to understand. Yes, when you take on more risk you expect a higher return, but you should also understand —
SCHATZKER: Hope for a higher return.
HOWARD MARKS: You hope, yes, but you should also understand that the range of possible outcomes becomes wider. With T-bills there’s no uncertainty. With the five-year there’s a little uncertainty. With corporates there’s a bunch. With stocks there’s more. The more risk you take, the more uncertain the outcome is, and the worse the bad ones are.
SCHATZKER: You’ve got a good information for this, right? You have — you have — and you show this in your most recent letter what the traditional model of risk versus return looks like versus the — I won’t call it the Marxist model, but the Marx model of risk versus return, and this is what it looks like. So what are you showing us here?
HOWARD MARKS: Well on the left you have — thank you for doing that. On the left you have the normal presentation which shows that as risk goes up return goes up. On the right you — you have the same line but superimposed on it at each point is a probability distribution, Bell-shaped curve turned on its side. So as you can, as the risk goes up as you move from left to right, the return goes up, yes, the line slopes up to the right. But at the same time, the distributions become wider, the range of outcomes becomes greater, and the bad ones become worse. And eventually on the risky investments, if you get a bad outcome you lose money. That’s what risk is.
SCHATZKER: So what does this explain to us about investor behavior and the performance of financial markets?
HOWARD MARKS: Well, what it explains I think is that people put themselves — they try to make more money by taking more risk. When things go well, they make more money.
SCHATZKER: As they are now.
HOWARD MARKS: As they are now. As they — they tend to conclude, that means that riskier assets produce higher returns and they go out for even more risk and eventually they find out about the other part of that drawing.
RUHLE: What’s the difference between volatility and risk? Because oftentimes people lump them together and they don’t actually mean the same thing. Volatility is a temporary fluctuation. Risk in my opinion is permanent loss. So in other words, everybody had a big decline in the crisis of ’08. By the end of ’09, most things were back to where they had been. If you didn’t sell in the crisis, you didn’t crystallize that loss.
You — you experienced the fluctuation but you didn’t turn it into a permanent loss by selling. And that’s really the key. Can you hold on through? Do you have the nerve? Do you have the conviction? Do you have the financial staying power? Are you going to not be fired by your clients? But volatility is relatively benign. It doesn’t feel that way at the time, but it’s benign if you can hold on.
SCHATZKER: Howard, you have summarized your views on what risk is in four key points, and I think we’ve got them together in a graphic so we can walk through them to help people to understand the point that you’re trying to make. First of all, you say the future shouldn’t be viewed as a fixed outcome but a range of possibilities. Why is that important?
HOWARD MARKS: You shouldn’t think you know what’s going to happen.
SCHATZKER: But so many people do.
HOWARD MARKS: Well, but they’re wrong.
SCHATZKER: They’re professional prognosticators.
HOWARD MARKS: Exactly. That’s an oxymoron. Mark Twain said it ain’t what you don’t know that gets you into travel. It’s what you know for certain that just ain’t true.
RUHLE: One more time?
HOWARD MARKS: It’s not what you don’t know that gets you into trouble. It’s what you know for certain that just ain’t true. If you think you know something and act in certitude and turn out to be wrong, that’s how you lose a lot of money. If you say I’m really not sure what’s going to happen, I’m going to hedge my bets and diversify my portfolio, you’re less likely to get into trouble.
RUHLE: You’ve said before you never say never.
HOWARD MARKS: Well you never say never and you never always.
SCHATZKER: So your point number two, risk means more things can happen than will happen.
HOWARD MARKS: Well that’s the point. Everybody says what’s going to happen to interest rates next year? What’s going to happen to GDP next year? Everybody will give you a number, but the point is even if you’re — even if you think you know what is the most likely outcome and even if you’re right, lots of other things can still happen.