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Howard Marks Masterclass on Risk Management

Seldom you see people explaining things that worry investors or even intermediate active managers and put them out clearly in a few phrases. Howard Marks, chairman of Oaktree capital is one of them. He has a latest newsletter out here (pdf copy) and transcript here. Its basically like an investor must read.

He went on Bloomberg to give a master class. I picked out some of the best snippets.


The talk of higher risk higher returns

“Higher — riskier — riskier investments have higher returns. So if you want to make more money, take more risk. It can’t be right, because if riskier could be counted on to produce higher returns, they wouldn’t be riskier. It’s at simple as that. There’s got to be something wrong with that formation.

What we should say is that investments that appear riskier have to appear to offer higher returns or nobody will make them. But that doesn’t mean it has to come true. And lots of things other — lots of things can happen other than what you hope will happen.”

The difference between Volatility and Risk

“Volatility is a temporary fluctuation. Risk in my opinion is permanent loss. So in other words, everybody had a big decline in the crisis of ’08. By the end of ’09, most things were back to where they had been. If you didn’t sell in the crisis, you didn’t crystallize that loss.

You — you experienced the fluctuation but you didn’t turn it into a permanent loss by selling. And that’s really the key. Can you hold on through? Do you have the nerve? Do you have the conviction? Do you have the financial staying power? Are you going to not be fired by your clients? But volatility is relatively benign. It doesn’t feel that way at the time, but it’s benign if you can hold on.”

Biggest Risk: What you think you know for certain which isn’t true

“It’s not what you don’t know that gets you into trouble. It’s what you know for certain that just ain’t true. If you think you know something and act in certitude and turn out to be wrong, that’s how you lose a lot of money. If you say I’m really not sure what’s going to happen, I’m going to hedge my bets and diversify my portfolio, you’re less likely to get into trouble.”

Preparing for another GFC and preparing for a Probability Distribution of Outcomes

“Now having said that, Stephanie, that introduces one of the great conundrums in investing. Because what you said is you should be — you shouldn’t hold asset classes that — that you — where you’d have to sell if things go wrong.

How bad could it get? Do we have to be prepared every day for a rerun of ’08? In that case nobody would hold anything. So again, you have to look at it as a probability distribution. You might want to prepare for the middle of the probability distribution, but sometimes you get into the tails.”

Knowing the probabilities doesn’t mean you know what’s going to happen.

Playing Offense or Defence when required, Missing out on opportunity versus not Losing Money

“I think that every investor faces two risks. Now if I say to you, Erik, what are the two risks, you’d get an A if you say the main one is the risk of losing money. But if you want to get an A plus you have to say the second one, and that is the risk of missing opportunity.


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