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Oaktree Capital Management chairman and co-founder Howard Marks is one of those rare money managers who is prized for both his investment performance and his market wisdom. Marks, 65, started to articulate his investment philosophy — which emphasizes risk control and consistency — in the early 1990s writing memos to clients as a portfolio manager at Trust Co. of the West. He continued that practice after he and five colleagues left TCW to start Oaktree in 1995. Today the Los Angeles–based firm manages $82 billion and has more than 650 employees and offices in Frankfurt; Hong Kong; London; New York; Seoul; Singapore; Stamford, Connecticut; and Tokyo.

For Marks, who began his career in 1969 as an equity research analyst at Citicorp Investment Management, one of the keys to investing is to avoid losses. “The No. 1 job of a professional investor is not to make a lot of money; it’s to control risk,” he explains. “If most people had understood that, we would not have had the financial crisis.” In his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, published this month by Columbia University Press, Marks dedicates three chapters to risk; the text excerpted here comes from the first of them. But Marks — who incorporates passages from his investor memos into his book to bring home his points — has no illusions that he will be able to convert longtime investors to his investment philosophy. “The book is mostly directed at young people,” he says. “I’m looking to inform the uninformed.” — Michael Peltz

In this excerpt from his book "The Most Important Thing," Oaktree co-founder Howard Marks reveals his insights into how to understand risk.

“Risk means more things can happen than will happen.”

— Elroy Dimson

Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable. Thus, dealing with risk is an essential — I think the essential — element in investing. It’s not hard to find investments that might go up. If you can find enough of these, you’ll have moved in the right direction. But you’re unlikely to succeed for long if you haven’t dealt explicitly with risk. The first step consists of understanding it. The second step is recognizing when it’s high. The critical final step is controlling it. Because the issue is so complex and so important, I devote three chapters to examining risk in depth.

Why do I say risk assessment is such an essential element in the investment process? There are three powerful reasons.

First, risk is a bad thing, and most level-headed people want to avoid or minimize it. It is an underlying assumption in financial theory that people are naturally risk-averse, meaning they’d rather take less risk than more. Thus, for starters, an investor considering a given investment has to make judgments about how risky it is and whether he or she can live with the absolute quantum of risk.

Second, when you’re considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher prospective returns to take incremental risks. Put simply, if both a U.S. Treasury note and small company stock appeared likely to return 7 percent per year, everyone would rush to buy the former (driving up its price and reducing its prospective return) and dump the latter (driving down its price and thus increasing its return). This process of adjusting relative prices, which economists call equilibration, is supposed to render prospective returns proportional to risk.

So, going beyond determining whether he or she can bear the absolute amount of risk that is attendant, the investor’s second job is to determine whether the return on a given investment justifies taking the risk. Clearly, return tells just half of the story, and risk assessment is required.

Third, when you consider investment results, the return means only so much by itself; the risk taken has to be assessed as well. Was the return achieved in safe instruments or risky ones? In fixed-income securities or stocks? In large, established companies or smaller, shakier ones? In liquid stocks and bonds or illiquid private placements? With help from leverage or without it? In a concentrated portfolio or a diversified one?

Surely investors who get their statements and find that their accounts made 10 percent for the year don’t know whether their money managers did a good job or a bad one. In order to reach a conclusion, they have to have some idea about how much risk their managers took. In other words, they have to have a feeling for “risk-adjusted return.”

It is from the relationship between risk and return that arises the graphic representation that has become ubiquitous in the investment world. It shows a “capital market line” that slopes upward to the right, indicating the positive relationship between risk and return. Markets set themselves up so that riskier assets appear to offer higher returns. If that weren’t the case, who would buy them?

The familiar graph of the risk-return relationship is elegant in its simplicity. Unfortunately, many have drawn from it an erroneous conclusion that gets them into trouble.

Risk - Return

Especially in good times, far too many people can be overheard saying, “Riskier investments provide higher returns. If you want to make more money, the answer is to take more risk.” But riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple: If riskier investments reliably produced higher returns, they wouldn’t be riskier!

The correct formulation is that in order to attract capital, riskier investments have to offer the prospect of higher returns, or higher promised returns, or higher expected returns. But there’s absolutely nothing to say those higher prospective returns have to materialize.

The way I conceptualize the capital market line makes it easier for me to relate to the relationship underlying it all.

 Riskier investments are those for which the outcome is less certain. That is, the probability distribution of returns is wider. When priced fairly, riskier investments should entail:

• higher expected returns,

• the possibility of lower returns, and

• in some cases, the possibility of losses.

The traditional risk-return graph is deceptive because it communicates the positive connection between risk and return but fails to suggest the uncertainty involved. It has brought a lot of people a lot of misery through its unwavering intimation that taking more risk leads to making more money.

I hope my version of the graph is more helpful. It’s meant to suggest both the positive relationship between risk and expected return and the fact that uncertainty about the return and the possibility of loss increases as risk increases.

“Risk,” January 19, 2006

OUR NEXT MAJOR TASK is to define risk. What exactly does it involve? We can get an idea from its synonyms: danger, hazard, jeopardy, peril. They all sound like reasonable candidates, and pretty undesirable. And yet, finance theory (the same theory that contributed the risk-return graph shown at the top of this page and the concept of risk-adjustment) defines risk very precisely as volatility (or variability or deviation). None of these conveys the necessary sense of “peril.”

Risk - Reward

According to the academicians who developed capital market theory, risk equals volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition of risk.

It’s my view that — knowingly or unknowingly — academicians settled on volatility as the proxy for risk as a matter of convenience. They needed a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risk do not. The problem with all of this, however, is that I just don’t think volatility is the risk most investors care about.

There are many kinds of risk. . . . But volatility may be the least relevant of them all. Theory says investors demand more return from investments that are more volatile. But for the market to set the prices for investments such that more volatile investments will appear likely to produce higher returns, there have to be people demanding that relationship, and I haven’t met them yet. I’ve never heard anyone at Oaktree — or anywhere else, for that matter — say, “I won’t buy it, because its price might show big fluctuations,” or “I won’t buy it, because it might have a down quarter.” Thus, it’s hard for me to believe volatility is the risk investors factor in when setting prices and prospective returns.

Rather than volatility, I think people decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return. To me, “I need more upside potential because I’m afraid I could lose money” makes an awful lot more sense than “I need more upside potential because I’m afraid the price may fluctuate.” No, I’m sure “risk” is — first and foremost — the likelihood of losing money.

“Risk,” January 19, 2006

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