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Hey everyone, how's it going? Welcome to my channel, The Financier. If this is your first time here, we talk about financial education and investments, and we're going to continue our series of studies on Howard Marx 's book, "The Most Important Thing for the Investor." He's a great investor and co-founder of Capital, and in the first video, we talked about two things he considers very important: second-level thinking and the concept of value.
Today, we're going to study what he considers most important, in my understanding, when I read this book: risk. He dedicates more than a chapter to it because he understands it as the central point of investing. He has a phrase that says investing is paying attention to the future, and since none of us can predict the future, we always take risks.
So how can we have a healthy relationship with risk? If we're going to talk about risk, risk is something bad, something we want to avoid. However, more modern economic theory has brought a concept of risk, based on the school he studied at, the Won School of Chicago, if I'm not mistaken. So the idea is that the higher the return...
If you want to take on more risk, you'll have to take more, right? So, the higher the risk, the higher the return you're willing to receive. And by return, I mean yield, your profitability. So, for this, a graph called the SML, or Security Market Line, was developed. You 'll see it here on the screen where you can see that this line is always rising, meaning that at a certain point you'll have a risk-free rate.
Let 's say it was the Selic rate in Brazil, and the further you go beyond this line, the more your return increases. However, your risk also increases. From this, concepts were developed to quantify risk. So today, for example, we talk about volatility. Volatility is measured by standard deviation. Standard deviation, going back to our math lessons, would be how far that sequence of numbers is from its average.
So, for example, if you have a very high standard deviation, it means that those numbers are very volatile. And this high volatility means, according to this theory, that there is a much higher risk. So, for them, volatility is risk. But Howard Marx here says the following: well, this doesn't seem to be the most human concept of risk.
For example... When you're going to make any investment, you don't just think, "Oh, this is very volatile, so I'm going to stay out because it's very volatile." It's not quite like that. Naturally, the risk will vary from person to person. So, measures like volatility and the Sharpe ratio, which is how much return you can get, are a simplified measure of risk, meaning how much risk you took to obtain a return.
Ultimately, volatility and the Sharpe ratio don't show the real risk of something. They do have some use, but they're not the main factor. The risk varies from person to person. For example, in an investment, one person might fear losing money; that's the biggest risk for them. For another person, it might be the risk of earning little.
For yet another, the risk could be liquidity risk, meaning the ability to recover your investment. So, for example, you invest in a CDB (Certificate of Deposit) that you can only redeem in 3 years. That's a liquidity risk – the risk of losing that money before then and not being able to. So, for some people, the risk is precisely that of liquidity.
See how... It varies from person to person, so a simple measure like the standard risk assessment wouldn't capture another point about risk: it ends up being hidden, futuristic, and theoretical because what we actually know is practice. Just imagine a meteorologist on TV saying, " Look, the probability of rain today is 70%." If it rains, he'll be right; if it doesn't rain, he'll also be right because it's simply a probability.
That's why when you look at the results of an investment portfolio you made or an investment fund and see that the fund had a return of 12%, you can't know how much risk that person took, that manager took, or how much risk you yourself took in your investment portfolio because the result is only one, but the probabilities are many.
So, let's say you make an investment that has a 99% chance of having a positive result and a 1% chance of having a negative result, but that 1% happens. It means you invested safely or unsafely. So you see, it's very much in the realm of probability; nobody can predict the future, and when we see the final result...
He is one of thousands of possible outcomes, and a major criticism from Howard Marx regarding risk assessment tools like VAR (Value at Risk), which is widely used by investment funds and professional managers, is that they cannot measure extreme situations because when you use these models, they only go up to a certain limit of what has already happened in the past.
But we human beings, Howard Marx argues, have this tendency to underestimate the past, and he bases this heavily on Nicolas Taleb, who is also a famous author and has books like *The Logic of the Black Man* and *Fooled by Randomness*, where he says that we are often confused or deceived by the possibility that we look to the past and tend to think that the past will always repeat itself.
An example is COVID-19; nobody was expecting it, right? So how can you create an investment model that will predict that? You know? So there are these difficulties, and when I talk about investments in lectures, courses, or consulting, I always say that anything can happen. We are in Brazil, for example, where the direct treasury is the safest investment in Brazil, but it could be that...
The government defaulting is difficult, very difficult, but it can happen because I don't have all the tools to predict the future; nobody does, you know? And investment funds, managers who have many people working for them, can't predict the future either; the future belongs to God. So, because of this difficulty, you have to understand that risk will always be present, and I always say that risk isn't just in investments; it's in your personal relationships.
Look, you've probably had a relationship, and that relationship ended, but when you started, you thought it would last forever. Most people think like that, right? I'm going to get into a relationship, and then it will evolve into marriage and everything else, and so on. So you didn't expect it to end.
Or you lost a loved one younger than you; you didn't expect that person, your friend, etc., to die sooner. But every time we commit ourselves, and speaking of relationships, there's always a risk of that relationship being broken, whether by the other party, by death, or even by you. So, if there's risk even in these things, how could there not be risk in investments?
Notice then that risk is part of it; there's no such thing as a completely risk-free investment, no matter how much... Investment theory: if we use Brazil's SELIC rate or the American interest rate as a risk-free rate, there is no such thing as a risk-free investment. This leads us to another point that Hart Marx talks about: we need to recognize and control risk.
In other words, recognize—as I just mentioned— we need to understand that risk exists. We ca n't run away from it, because if we completely avoid risk, we won't get a return. What would completely avoid risk be? "Oh, I'll leave my money under a mattress," and even then there's risk because, I do n't know, if your house catches fire, the money goes with it.
"Oh, but I'll put my money in gold bars, which fire won't destroy, but someone could still steal them." So there's no such thing as being completely free from risk. So you have to recognize it. And then the other point is control. And how can we control risk? Hart Marx does n't teach his risk control methodology in the book; he has his own method for that.
But one of the things he talks about is the issue of value, which I also mentioned in the previous video. In other words, the cheaper something is, the better. Investing cheaply means that the price you're paying is much lower than the asset's value. For example, you're going to invest in a stock that you know the value of—of course, most of us would need to do a lot of research to know, right?
But let's say you've done all the possible research and found that the stock is worth R$5, right? But its current price is R$2. So you see, " Wow, there's a difference here, it's cheap!" So if I invest in it, I'll take less risk because if it falls, I'll lose less, and my potential gain is much greater.
This is a simplified explanation. For example, when you invest in CDBs and other Treasury Direct bonds, where you seek a much higher rate, the higher the rate, the more discount you're getting when buying that asset. So think about this when investing, in terms of value, because the less risk you take in terms of value, the less risk you're taking in general.
Remember that risk is not something we can measure or quantify because if we only look at the past, the past doesn't repeat itself in the future. It's like Kazusa saying that I see the future repeating the past. It's true that investing has principles and rules, but it 's not a recipe; in other words, the future is uncertain.
Therefore, we have to be very careful and recognize that risk is part not only of investing but of life. Another point he'll make here, to move us towards the end of this video, is that in the long term, it's better to be defensive than aggressive. He even cites an article called " The Losers' Game," where the author's name ( I've forgotten the name, but I'll put it below) says that he compares investing to a game of tennis, specifically amateur tennis.
He realized that in amateur tennis, the player who makes fewer mistakes wins more often. Why? Because you play and just pass the ball, inducing your opponent to make mistakes, where most points are won by the opponent's errors. Here in investing, although we're not competing directly with anyone, we are in the market, right?
Generally, it's a game of wins and loses; someone is winning, someone is losing. Especially when... We talk about stocks because someone is selling and someone is buying. It's not 100% true, but there's a bit of that competition too. The issue of playing defensively in the long run will bring you better results because if you play very aggressively, when you have a large loss, it's much more difficult to recover.
Speaking numerically, if you have a 50% loss in your portfolio, to recover you have to have a 100% gain. For example, let's say you have 10,000 invested in stocks, a big crisis happens and it falls 50%, meaning your 10,000 becomes 5,000. To recover that investment, it doesn't have to yield 50% again.
Because if it yields 50%, you 'll have a gain of 2,500. So you would be left with 7,500. You would have to have a 100% gain on what's left, and that's much more difficult, isn't it? A 100% gain. So when you are exposed to very large losses, you will have difficulty recovering that value, that's why...
He says that in the long run it's better to play defensively. If you've already read this book or are considering buying it, I want to add a few things here. He also talks a bit about the vision of an investment manager, as he is. So, the manager of an investment fund doesn't have the mindset of an average investor like you and me because the manager has to be accountable to the fund's shareholders, to the fund's investors.
You and I don't have to be accountable to anyone unless you're an investment fund manager. So you're only accountable to yourself. So, a little of what he says here is related to this part of investment fund management, but a good part is also related to you and me, ordinary investors. And I also want to invite you to continue this series.
This book is very rich, so there are some other factors he mentions that I want to bring to you, for example, the issue of market cycles, the market pendulum that he also mentions, and the issue of opportunities, the role of luck, and also the psychological factors in investments. So there's still a lot to talk about in this book.
If you're enjoying it, leave a comment below. Do you also have any book suggestions? I recommend you post them here so we can discuss reading this book and bring up this topic together. And of course, if you liked this video, please leave a like and subscribe to the channel if you haven't already! That will help us grow a lot and continue bringing you content.
So that's it, folks, until next time. God bless you, a big hug, and we're in this together!
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