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Howard Marks says a falling price is not necessarily risk. So what is risk, really? This is the series Investors and the Brain, which tells real events from the market and research on how investors tend to decide. Marks is a co-founder of the asset manager Oaktree Capital in Los Angeles and has written letters to investors for more than thirty years.
Suppose the stock you are holding has just fallen thirty percent. According to Marks, a price drop alone is not enough to call it risk. Real risk, in his view, is losing money and never getting it back. At the end of this video, in Marks's own words, we will answer two questions: what is risk really, and why is it when we feel safest that things are often most dangerous?
The source of this video is Marks's memos, the long letters he writes to explain what he thinks about the market. He began writing in 1990, and all of them are now public on the Oaktree website. In 1995, he and four others founded Oaktree. Risk is a subject he keeps coming back to, starting with the first memo devoted to it in 2006.
In 2011, his book The Most Important Thing had three chapters out of twenty about risk. In 2014 he wrote Risk Revisited, meaning a fresh look at risk, and in 2015 he added one more update. Risk is so hard that people who have worked in the field for over thirty years still have to rethink it, so it is no surprise if you find it hard to grasp.
This video goes through five ideas from those memos, from the easiest to see to the hardest. The first idea is to separate two things that many people lump into one. Marks writes that volatility, meaning short-term price swings, is far from enough to define risk. In his view, the bigger worry is permanent loss, money that is gone and never comes back: "We can ride out volatility, but we never get a chance to undo a permanent loss." The channel's analogy: a rocking boat is volatility, a hole in the hull is the real loss.
Now a hypothetical example from the channel, not from Marks: a stock priced at one hundred thousand dong. The first person buys ten shares with one million dong of their own money. The second person adds one million dong borrowed from the brokerage and buys twenty shares. The price falls to sixty thousand dong.
The first person still has six hundred thousand on paper and sits tight. The second person has two hundred thousand left after paying the debt, is asked to put in more money and sells right at the bottom. A year later the price is back to one hundred thousand: the first person has the full one million, the second has only two hundred thousand.
You can't be a good investor if your emotions dominate you, because then you'll make the same mistakes as everybody else in the market. You'll buy too much when things get too exciting and prices are too high, and you'll get depressed and sell when things are too low and everybody else is selling. Marks says that when emotions take over, we buy too much when we are excited and panic-sell when prices are low.
Panic selling means selling off in a rush out of despair. So real risk is when a temporary drop in price turns into a permanent loss of capital. This helps you ask yourself before buying: if the price fell by half, would I be forced to sell? The second idea is about the very numbers that measure risk.
In the 2015 update, Marks quotes Peter Bernstein, author of Against the Gods, a book that tells the story of risk. Bernstein wrote in 2007: "In life – and in investing – the biggest risks cannot be reduced to a hard number." He added that the main danger of managing risk with models is the illusion of control, the feeling of having a grip on everything that the model gives us.
He gave a numerical example. A result called statistically significant, meaning ninety-five percent certain: "95% still leaves 5% you know nothing about." Bernstein concluded that the devil is in the residual, the part the model cannot explain. Marks also quotes Ric Kayne, a friend and a very good investor.
Kayne said: "Most of financial history has taken place within two standard deviations, but everything interesting has occurred outside of two standard deviations." Standard deviation is a common measure of how much prices fluctuate. The way the channel reads it, ordinary days are easy to predict, while the memorable days lie outside that zone.
This helps you read a risk number correctly: it tells you about the familiar days, but promises nothing about the worst day. The third idea is about the worst-case scenario. Marks writes that the worst-case forecast often turns out not bad enough, because what the forecaster means is only a bad scenario.
Maybe the worst is only the worst we have seen. "But that doesn't mean things can't be worse in the future." In the 2015 update, he tells his father's story about a compulsive gambler. One day, hearing about a race with just one horse, the man bet his rent money. Halfway around the track, the horse jumped the fence and ran away.
Marks wrote: "Risk shows up lumpily." He quotes Ben Graham and David Dodd, authors of Security Analysis, the 1940 edition, writing that "investment losses are not distributed fairly evenly in point of time, but tend to be concentrated at intervals" According to Marks, in those stretches there are always people who cannot hold on, especially those who borrowed heavily to invest.
This helps you ask yourself: if things get worse than the worst I have seen, will I still be in the game? The three ideas so far connect into one thread. Risk is permanent loss of money, risk numbers miss the part we do not know, and the worst case we imagine is often still too mild. The next idea changes the angle completely.
The fourth idea moves elsewhere: risk also lies in how we behave when we feel safe. Marks named this phenomenon the perversity of risk, roughly the paradox of risk. He wrote: "The riskiest thing in the world is the widespread belief that there's no risk." The channel reads it this way: when we feel safest, risk is highest.
In 2017 he wrote that when money is more plentiful than ideas, the fear of risk dries up, people become more trusting and investing standards loosen. Marks put it concisely: risk is low when risk awareness is high, and high when that awareness is low. The reverse, as the channel reads it: when everyone is afraid, people will only buy at lower prices, and a low price is a cushion for the buyer.
He also wrote that "At bottom, the riskiest thing is overpaying for an asset (regardless of its quality)" Anybody who came into this business since 1980, which I imagine includes most of you, have only seen declining interest rates or ultra-low interest rates, or both. And I don't believe that the next 10 years will be characterized by declining interest rates or ultra-low interest rates.
And that's a major change in the environment. The declining interest rates over that period and the ultra-low interest rates were like a moving walkway at the airport. And you get on the walkway, and you walk at your normal speed, and you make great progress over the ground, and you say, 'Boy, I'm fit.' But it's not you.
Marks says falling interest rates are like an airport moving walkway: we think we are going fast because we are fit, but it is not thanks to us. Cheap borrowed money pushes asset prices up, so investors think it is thanks to their own skill. When we feel safest, real risk is easily overlooked. This gives you two questions to ask before buying: what price am I paying, and how safe does the crowd around me feel?
So how do we recognize when risk is building up? Across many memos, Marks describes signs that tend to appear together, and the channel groups them into five. The first sign is the belief that risk has disappeared, as Marks wrote in 2009. The second is that the fear of risk is gone, according to the 2001 memo.
We're supposed to be afraid of losing money, our own and our clients. But in a bubble, bubbles go where they go because FOMO takes over from the fear of losing money. People become petrified that somebody else will be in something and they won't be in it and they'll have to kick themselves or they'll lose out competitively.
Marks says that in a bubble, the fear of missing out overwhelms the fear of losing money, so everyone is afraid of being left outside. A bubble is when prices are pushed far from value because the crowd rushes in. No longer fearing loss does not mean the risk is gone. The third is that lending standards loosen, in the same memo.
The fourth is that new financial products flourish, according to the 2007 memo. The fifth is that buyers no longer care about price, according to the 2017 memo. None of these signs is a sell signal by itself, but when you see many at once, you can check again how you are borrowing and what price you are paying.
The last idea is why Marks does not believe in forecasts. He sides with the economist John Kenneth Galbraith, who said: "We have two classes of forecasters: Those who don't know – and those who don't know they don't know." Marks splits what we do not know into two kinds: the things we know we do not know, like government actions or the coming price of commodities.
And the things no one thinks of, like the attack of September 11 or the Fukushima disaster. Marks wrote that the chance of loss is as hard to measure as the chance of rain. The chance of losing money can be estimated, but it cannot be known exactly. So he advises looking at the future as a range of possibilities, with two questions: which events could happen, and how likely is each?
For the most part. Their probability distribution governing their future returns or future developments looks something like this. Your standard bell-shaped curve. Historically, of course, for the last 100 years, the S&P has averaged 10% return, so quite good, but sometimes 20 and sometimes zero for maybe a decade.
Marks says the S&P has averaged ten percent a year, but there are decades with twenty and decades with zero. The S&P is an index of five hundred large American companies. A nice average does not announce the coming decade, so risk still sits in the bad period. This helps you change the question from where the price will go to which scenarios could happen, and whether you would survive the bad one.
In a 2003 memo, Marks calls himself: "I'm a card-carrying member of the 'I don't know school.'" His 2001 memo is titled You Can't Predict. You Can Prepare, meaning we cannot predict but we can prepare. The way to prepare, he says, is to leave a margin of safety, meaning room for error, and a low price is exactly that room.
The channel sums it up as three levels of investor, which is not Marks's words. Level one tries to guess the future, level two prepares for the future, level three prepares for many futures, including very bad ones. Back to the opening question: what is risk really, and why is it most dangerous when we feel safest?
According to Howard Marks, risk is not only a falling price but money lost and never recovered, and the riskiest thing is the widespread belief that there is no risk. So the biggest risk comes just when everyone feels safest. The channel's summary: at such times people borrow more, pay higher prices and loosen their standards.
A self-check from the channel: before your next purchase, try writing three scenarios, good, ordinary and bad, then ask whether you could survive the bad one. And you, have you ever felt safest right when the market was about to turn? Tell me in the comments. Thank you, dear viewers, for listening. I am Thân Mậu Khương, a person passionate about stock investing.
I always take the philosophy of value investing, perseverance, discipline and strict risk management as my compass on the journey to financial freedom, and spread positive things to the community.
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