The Practical Way

Sunday, 16th October 2011

Howard Marks Investing Ideas, part 2

Written by George Traganidas Topics: Stock Investing, Wealth Building

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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.

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.

Follow the practical way,
George

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