By Ben Carlson, A Wealth of Common Sense
“Investors face not one but two major risks: the risk of losing money and the risk of missing opportunities.” – Howard Marks
Howard Marks updated his masterpiece this week on how he looks at risk in the markets in his latest quarterly update in a memo called Risk Revisited Again. Whenever someone as well-respected as Marks writes such a thought-provoking piece there’s bound to be plenty of reaction and commentary.
Marks wrote close to 20 pages on the topic and investors still couldn’t agree with him on how to define the term ‘risk.’ According to investors, risk could be defined as:
The permanent loss of capital, volatility, not know what you’re doing, uncertainty, what’s left over after you’ve thought of everything, black swan events, drawdowns, running out of money before you die, missing out on huge gains, taking part in huge losses, not hitting certain performance targets, the price you pay for an asset, making a huge mistake at the wrong time and complacency.
There’s also systematic (undiversifiable) and unsystematic risk (diversifiable) in stocks. In bonds there’s credit risk, duration risk, inflation risk and interest rate risk. You also have to worry recessions, geopolitical events and bad luck. In the professional money management business, career risk always has to be taken into account. The list could go on.
All of these things could be definitions of risk depending on how you react to certain situations. I always say that the biggest risk is not reaching your goals, but that’s just one risk to consider, and most people’s goals are moving targets anyways, so it’s an incomplete definition.
Professional investors would love to be able to come up with a concrete definition of risk and they don’t mind spending money searching for it. The thought process is that if all risks can be measured accurately then they can be hedged away. This leads investors to hedge out their hedges to the point where there’s now no risk being taken which subsequently leads to no returns either. Whether you measure risk or not, you still have to bear it at some point to make money in the markets. There are no shortcuts.
In an interview with Bloomberg this week, Marks shared this interesting stat on risk management:
“I think more money was spent on risk management in the early 2000s than in the rest of history combined and yet we experienced the worst financial crisis in 80 years,” said Marks. “There’s little evidence that they add value,” he said of the statistical models.
It’s worth remembering that humans create these models and they’re only as good as the assumptions used. The risk models created by investors and financial institutions leading up to the financial crisis were the epitome of garbage-in, garbage-out. One of the biggest fallacies in the world of professional money management is that risk measurement is the same thing as risk management. Investors are constantly trying to turn risk management from an art into a science.
It’s never going to happen.
I don’t have a perfect definition for risk because I don’t think one exists. Risk means different things to different people at different times. You cannot define risk or risk tolerance without first assessing the unique characteristics of the investor in question. Risk is personal.
The late Peter Bernstein once said, “The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.”
I’m a big believer in focusing on what you control as a form of risk management. While we’re never going to be able to perfectly measure risk, one of the best ways to manage risk is to have a comprehensive plan in place. Having a plan doesn’t mean you can eliminate risk altogether. That’s impossible. Taking risk makes sense. You just don’t want to get into the habit or taking unnecessary or unacceptable risks.
Now all you have to do is figure out what those unacceptable risks are.
Here’s what I’ve been reading lately:
- We are not as smart, or unbiased, as we think (Abnormal Returns)
- Financial journalism operational guidelines (Prag Cap)
- The 5 greatest bull market rock albums of the 1990s (Midnight Trader)
- 10 big lies in the financial services industry (Above the Market)
- Reminiscences (Irrelevant Investor)
- Channeling The Stokes’ song Is This It in terms of a potential bond market crash (Monevator)
- Things are great now, but winter is coming eventually in your portfolio (Washington Post)
- 5 bedrock principles for investors (WSJ)
- The messed up relationship between jobs, stocks, interest rates and the economy (Reformed Broker)
- Set it and forget it really does work (Rick Ferri)
- Mother nature designed you to be a terrible investor (What Works on Wall St)
Latest posts by Ben Carlson (see all)
- The Four Signs of a Pending Bear Market - 06/18/2015
- Will Retiring Baby Boomers Ruin Future Market Returns? - 06/17/2015
- The Struggle to Define Risk - 06/12/2015
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