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Welcome to Finance with AI's YouTube channel. Today we will delve into a very important book, The Most Important Thing by Howard Marks. You can say that this book is like the Gita or the Bible for those investors who invest money thoughtfully. We will not talk about the entire book but will focus on its most important part i.e.
risk. People often ask how much return will they get? But Howard Marks says the biggest question is how much risk there is. Today we will understand why looking at this question in a general way is the biggest mistake? For this we will take the help of Chapters Five, Six and Seven. Understanding, identifying and ultimately controlling risk.
Correct. Because Marx's co-argument is that investing means dealing with the future and the future is by definition uncertain. Therefore, it is impossible to avoid risk. The real game is to handle risk and this is the most important element of investing. So let's start with the first step. Chapter Five Understanding Risk.
I have heard the same thing in finance classes since childhood. Seen a graph with a straight line going up. More risk, more return. The more risk you take, the more returns you will get. Is this true? This is the biggest and I would say the most dangerous misconception. Marks completely challenges that arm capital market line graph.
He says that there is no guarantee that riskier investments will yield higher returns. Good. If this were so then why would he be called riskier? They just have to offer a prospect of higher returns or a high expected return to attract capital from the market. Well, this isn't a guarantee, but more like a marketing pitch.
Invest with us and maybe earn more. Exactly. Basically, riskier investments mean that the outcome is more uncertain. That means the probability distribution of returns is very wide. Therefore, Marx's graph is not a straight line but a cone that expands towards the right. Like a cone. Yes, as you increase risk, the range of potential outcomes also increases, both upwards and downwards.
You can earn a lot and also lose everything. Meaning it is not a straight road but a tunnel which widens as it goes further ahead. In which there is a path to the treasure and also to the ditch. So if this common definition is wrong, then what exactly is risk? Hmm. Finance theory says that risk equals volatility i.e.
price fluctuations. And Marx does not agree with this definition at all. For them, volatility, i.e., up-down fluctuations in price, is not the risk that a long-term investor should really care about. We consider volatility to be an academic convenience that can be put into numbers and fitted into formulas.
But imagine if you bought a stock at ₹100, it fell to ₹60 and then after a year it went to ₹150, did the fluctuations in between make any difference to you? No, in the end I am in 50% profit. It will matter to me if he goes from 100 to 60 and never comes back. This is exactly Marx's point. The real risk is the risk of permanent loss of capital.
Fear of losing money forever. Yes. And this means that risk does n't just come from the company's fundamentals. A weak company is not always risky and a great company is not always safe. One minute. This is a bit confusing. Meaning, how is it possible that a bad company can be safe and a good company can be risky?
Absolutely. Because the risk of loss comes not from the fundamentally weak asset but from the high price paid for it. From the price paid. Correct. Even the stock of a fairly average company can be a great investment if purchased at a very low price, and the reverse is equally true. Marks gives the example of Nifty 50 stocks of 1970.
It was one of America's 50 best One Decision Companies. everything was perfect. Business model, growth, management everything is perfect. But people were so enthusiastic that their PE ratios reached 80-90. This means that people were ready to pay 80-90 times his annual income. This is strange. Yes. And when the market finally returned to normal, the stocks of these great companies wiped out 80-90% of investors' money over the next few years.
Our company was great but the price was wrong and wrong price is the biggest source of risk. This also means that it is almost impossible to measure or quantify the risk. Why impossible? Because risk is in the future and when an event happens, you only see one outcome. Here Naseem Nicholas Talib's concept of alternative histories is very useful.
Alternative Histories. Yes, this means many possible outcomes that could have happened, but did not. Just because an investment is successful does not mean that the decision was wise. So this means that if someone plays Russian roulette and survives, we will not call him a genius but just lucky. The same thing happens in investing.
Absolutely. Marx says you're a lucky idiot. Maybe the investor took a bet that had 99 scenarios of failure and only one right to pass ? If that becomes a scenario, the world will call him a genius. But in reality, it could have been ruined 99 times. Therefore, the quality of the decision cannot be judged by the outcome.
Ok. So if risk is impossible to measure and a good outcome doesn't even indicate whether a decision was good or not, how can an investor recognize it in the market? What is there that he can see and say that there is danger here? This brings us to Chapter Six, Recognizing Risk. This is the most straightforward and, you might believe, the most opposite answer.
High risk arises when people believe there is no risk. It is created when investors become risk averse. They become very optimistic and are ready to pay any price for any asset. Wait, this is exactly the opposite. So the moment when there is least fear in the market is when everyone is saying that this is a sure shot.
Money cannot be lost in this. In fact, the risk is highest then. Precisely Marx calls this the perversity of risk. One of his famous quotes is Investment risk arises most where it is least perceived and vice versa. A bubble is formed only when everyone feels that the risk is over. That's correct. Because the lack of fear forces people to pay a price that leaves no room for error or margin of safety.
The 2007 financial crisis would be a perfect example, right? The most perfect. At that time, a general consensus had developed that the risk was gone. Many theories were being given for this. One theory was that globalization has spread risk across the world. Therefore, now he cannot concentrate at one place.
Another popular theory was that of securitization. Securitization is the same thing as CDOs. How to understand this in simple language? It is something to think about. These CDOs, or Collateralized Debt Obligations, were like a financial fruitcake. Fruit cake? Yes. Bankers would slice and dice thousands of different home loans, some good, some very bad, and mix them together and sell that mixture to investors as a new slice.
So the problem was that no one knew how much rotten fruit was in their slice. Absolutely. You feel like you're buying an awesome fruitcake, but it's rotten inside. Everyone felt that the risk had been transferred to those who could bear it better. But it was all a myth. Our risk is not over yet. It just goes from one hand to another.
And he finally got to people who did n't understand it at all. So what red flags should the average investor have seen at that time? What was happening that would make any sensible person say that something was wrong here? There were many things like delinquencies started increasing in sub prime models i.e.
low quality home loans. People were missing their loan payments. The CDOs that were created from these loans were failing. Two large funds of bearish turns, which were heavily invested in these things, suddenly collapsed. All these were signs of contagion i.e. spread of disease. Right? Out That You Find Out Who's Been Swimming Naked Everyone was dancing as long as the music was playing.
When the music stopped, I realized how hollow the system was from inside. It is like looking in a mirror. Recognizing risk means thinking against the crowd. But just recognizing it is not enough. How can an investor actively control this ? This brings us to the last part. Controlling Risk from Chapter.
And according to Marx, this is the most important thing. He says that great investors are known more for their ability to control risk than their return-generating ability. Anyone can get high returns in this bull market. A little luck is required but it is important to see how much risk was there behind that high return.
Consistent decent returns with low risk, this is real skill. But there is a practical problem in this. Risk control is not easily measured and is generally not appreciated. Especially when the market is doing well. Your friends are making 50% in meme stocks and you're 15% in your risk control portfolio now you look stupid.
Absolutely. Risk control is invisible. It is visible only when there is loss. Marcin gives a great analogy for this. He says homes built in California may contain construction faults. But they are not known until a major earthquake occurs. Right? In good times, risk control is like an insurance policy that does n't feel necessary.
It sounds boring, but its presence alone saves your portfolio from being ruined in bad times. So what is an investor's value add? Just bring the returns. There are two ways to add value. One takes the same risk as the benchmark and generates better returns, and the other is what Marks considers more important.
To generate returns similar to the benchmark but with lower risk. By taking less risk. Yes, this is a great accomplishment because it means you will have performed better in down markets and protected capital. The chapter also makes an important distinction between risk control and risk avoidance. So this does not mean that you should get scared and hide under the bed.
No, not at all. Risk control means avoiding losses. But risk avoidance also means avoiding returns. If you do n't want to take any risk at all, you will sit in cash and inflation will slowly eat away your money. The job of investing is to intelligently bear risk for profit. Taking risks wisely to make profits.
The analogy of a life insurance company is very good here. What is that? Look, life insurance companies know that every policy holder of theirs will die one day. This is a 100% certain risk. Still, how does she make a profit? Because they insure millions of people and they know that not everyone will die at the same time and they charge premium.
Exactly she knows this risk. Two analyses can be done from actuarial tables. Three diversifies across millions of policy holders. And they get a good premium for bearing this risk. A skilled investor also does the same with risky assets. He understands the risks, analyses them, diversifies his portfolio and invests in an asset only when the potential returns are high enough to justify taking that risk.
That is, when he is getting a good premium. So what is the most important takeaway for investors in the end ? What is the gist of all this? Invest scarred in a line. Always think about the possibility of loss. Invest Scared. Yes, be afraid that something might happen that you don't know about. This fear will protect you from arrogance and overconfidence.
This will force you to always insist on a margin of safety and keep your portfolio prepared for the storm you did not expect to come. So this is a kind of confident passimism. Be confident in your analysis. But always be aware that the future may prove you wrong. Well said and if nothing bad happens then Marx says the winners will take care of themselves.
A good portfolio will automatically go up. Your job is to avoid permanent loss. This journey of understanding, identifying and controlling investment-care risk was truly eye- opening. These three chapters of Howard Marks' book are so profound that they can change your entire perspective on investing. We will understand other chapters in the next video.
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