Sunday, 16th October 2011

Howard Marks Investing Ideas, part 2

Written by George Traganidas Topics: Stock Investing, Wealth Building

Telling the future

Making market forecasts on a consistent basis is not an easy thing. Many people try and none succeed on it. If you are always crying ‘wolf’ then at some point you will be right, but that does not tell us about your ability to forecast market movements. A useful market forecast is only useful if it is in contrary to popular belief. If everyone predicts it then this is already reflected in the price of assets. So in order to profit, you must find someone who consistently makes predictions that are contrary to popular belief, they are correct and you must have the courage to act on them. Not many people have the stomach to go against the crowd and feel confident about it.

When you try to predict the future you must be able to predict the future events and the timing of when they will happen. If you can not predict the timing your predictions are as good as the false ones.

People who know the future repeatedly ignore the fact that (a) the future possibilities cover a broad range, (b) some of them – the “black swans” – can’t even be imagined in advance, and (c) even if it’s possible to know which outcome is most likely, the others have a substantial combined probability of occurring instead.

The key is to view the future as a range of possibilities, no a reliable point estimate. If an investor prepares for a single future and attempts to maximise under the assumption that his view will prove right, he will be in big trouble if it does not. The investor who backs off from the maximising position is likely to do better when negative surprises occur. Thus it’s essential to realise a few things:

  • It is not sufficient to think about surviving “on average” – investment survival has to be achieved every day, under all circumstances.
  • The ability to survive under adverse conditions comes from a portfolio’s margin for error.
  • Ensuring sufficient margin for error and attempting to maximise returns are incompatible.

Investing consists of just one thing: choosing which assets to hold in order to profit in the future. Thus there’s no getting away from the need to make decisions concerning the future.

In deciding which future to prepare for, you need two things: (a) an opinion about what’s likely to happen and (b) a view on the probability that your opinion is right. Everyone knows about the former, but I think relatively few think about the latter.

In short, most people believe their opinions. “Of course they do, ” you might say. “If they didn’t have faith in their opinions, they wouldn’t hold them.” And that’s the point. Everyone’s entitled to his or her opinion. But one of our favourite sayings around Oaktree states that “it’s one thing to have an opinion, and something very different to act as if it’s right.”

Yet, as I see it, most people who believe in forecasting come up with their opinions and then act on them with equal amounts of confidence. This is one of the greatest sources of investment error.

It’s perfectly okay to say you don’t know something. It’s also okay to say you have a view on what might happen but you’re not so sure you’re right. In that case you’re likely to moderate your actions and emerge intact even if you turn out to be wrong.

Risk

According with the academicians who developed Capital Market Theory, risk equals volatility, because volatility indicates the unreliability of an investment. This definition of risk is not the best. Academicians use volatility to measure risk because it is convenient. It is a number that is objective and can be ascertained historically and extrapolated into the future. Volatility though is not the risk that most investors care about. Risk is the likelihood of losing money.

People believe that by increasing risk they will get higher returns. Riskier investments can not be counted to deliver higher returns, because if riskier investments reliably produced higher returns, they would not be riskier. Riskier investments offer the prospect of higher returns or higher promised returns or higher expected returns. But there is absolutely nothing to say those higher returns have to materialise.

Therefore what investors should look for are risk-adjusted returns. Can you achieve higher returns without assuming higher risk? This is very difficult to do in efficient markets, but in markets that are not efficient the risk and the return is not correlated the traditional way. It is possible to get higher returns and assuming lower risk.

Modern portfolio theory tells us that the market prices assets so they will offer returns that are proportional to their risk. In inefficient markets mistakes are made such that risk and return need not be strictly proportional. As a result, it becomes possible to achieve superior and inferior risk-adjusted returns.

It is not a matter of finding winners, but of building a portfolio where upside potential is accompanied by downside protection. In order to decide how well a portfolio had performed, you have to access how much return was achieved and how much risk was borne.

“I would not buy that at any price – everyone knows it is too risky.” Most investors think quality, as opposed to price, is the determinant of whether something is risky.

Taking too little risk can cause you to underperform your peers – but that beats the heck out of the consequences of taking too much risk at the wrong time. No one ever went bankrupt because of an excess of risk consciousness.

Risk comes from the combination of what you buy and how you finance it. You can buy very risky assets, but if you don’t lever up to do so, you’ll never lose them to a margin call. Or you can buy fundamentally safe assets, but the combination of enough leverage and a sufficient hostile environment can cause a meltdown. In other words, investing in “safe” assets isn’t necessarily safe, particularly if you’ve borrowed to buy them.

Investment safety doesn’t come from doing safe things, but from doing things safely.

Leverage + volatility = dynamite

Investors face two main risks: (1) the risk of losing money and (2) the risk of missing opportunity. Investors can eliminate one of the other, but not both. More commonly, they must consider how to balance the two. How they do so will have a great impact on their results. This is the old dilemma – greed or fear? – that people talk about so much. When most people think that the worst imaginable outcome is failing to participate fully in gains, the result is risky behaviour. They’re inevitably reminded that there’s worst, but it can take a long time to happen. One of the prominent features of investor psychology is that few people are able to (a) always balance the two risks or (b) emphasise the right one at the right time.

Hedging sounds easy: you own something, so you sell something else to lessen the impact if your investment performs badly. But there are lots of ways to be wrong.

  • Hedging the wrong thing. (e.g. Buying B to hedge A and when A declines so does B.)
  • Hedging in the wrong amount. (e.g. Buying 10 of B to hedge 10 of A.)
  • Time risk. (e.g. The two sides of the position may work as you expected, but not when you expect.)
  • Insufficient liquidity. (e.g. If you need the change your hedge there might be no market to buy or sell it.)

In other words, hedging consists of an attempt to cede some potential gain in exchange for a greater reduction in potential loss. It’s a very reasonable course of action. But it doesn’t necessarily have to work.

Risk control isn’t an action so much as it is a mindset. It stems largely from putting at least as much emphasis on avoiding mistakes as on doing great things.

Risk control – and consistent success in investing – requires an understanding of the fact that high returns don’t just come along for the picking; others must create them for us by making mistakes. And looked at that way, we’ll do a better job if we force ourselves to understand the mistake we think is being made, and why.

Risk control requires that we avoid the analytical and psychological errors to which others succumb.

In particular, risk control requires that we temper our belief in our opinions with acceptance of our fallibility.

Which of the two main risks with which investors have to content should you worry about more: the risk of losing money or the risk of missing opportunities? A skilled investor can eliminate one or the other of the risks, but nobody can eliminate them both. How, then, should one behave? You can put all your efforts into avoiding one risk or the other, but that’s imprudent. Or you can maintain a fixed balance between the two, but that seems to excessively ignore variation in the outlook for upside potential and downside risk. Instead, I think the right approach is to adjust you stance as the environment changes.

To me, the answer to this question lies primarily in the degree of cheapness prevailing in the markets. When asset prices are high, there’s more risk to be aware of and less opportunity to worry about missing. On the other hand, when prices are low, it’s appropriate to worry less about the risk of loss and more about missing out on the opportunities created by those low prices.

Everyone know that if you reach into a bag containing both black and white balls and pull out ten white ones in a row, the probability has increased that the next one will be black. But in the investment world, events like that server to convince people that there are only white balls – favourable outcomes – in the bag. That’s part of the illogical, emotional thinking that makes for bull markets and bubbles.

It is my firm belief that the riskiest thing in the investing world is widespread belief that there’s no risk. Usually that dangerous condition stems from excessive conviction that the future is knowable and known… and benign.

But the risk in an activity doesn’t stem from the activity itself, but from how people approach it. When equipment is developed that makes mountain climbing safer, people change their behaviour in ways that make it more risky. Equally, much of the risk in investing stems not from securities, companies or exchanges, but from investor behaviour. In short, risk is low when investors behave prudently and high when they don’t.

A world that’s perceived as safe can be rendered unsafe if the perception of safety causes investors to move out the risk curve, bid up prices, or take actions that assume greater certainty than turns out to be the case. Conversely, an uncertain world can be safer than people perceive if their concern causes them to behave cautiously (and especially if it causes them to sell down assets to prices from which the likelihood of further declines is reduced).

Follow the practical way,
George

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