Howard Marks' art of risk management

Howard Marks is a name that needs no introduction. His brilliance and insights are the fundamental drivers behind the success of his investment firm Oaktree Capital, reflected in his memos. In his latest memo, 'Fewer Losers, or More Winners?', Marks highlights the importance of steering clear of the losers to reduce downside risks.

The Oaktree Capital philosophy
"If we avoid the losers, the winners will take care of themselves" is a line that perfectly captures Marks' thought process, which later became the motto of Oaktree Capital. Along with risk reduction by avoiding losers, Marks stresses the importance of finding winners.

"If we invest in a diversified portfolio of bonds and can avoid the ones that default, some of the non-defaulters we buy will benefit from positive events, such as upgrades and takeovers. The winners will materialise without our having explicitly sought them out..."

Marks consistently emphasises risk control and evaluating risk rather than just focusing on returns. He continues, "We want the concept of risk control to always be at the top of the mind for our investment professionals. When they review security, we want them to ask not only, "How much money can I make if things go well? but also "What will happen if events don't go as planned? How much could I lose if things got bad? And how bad would things have to get?" "

Risk control vs risk avoidance
Marks insists that risk control should not be confused with risk avoidance. All investments carry a certain degree of risk. Investing is a forward-looking activity consisting of uncertainty while pursuing attractive returns. Putting money into riskless assets will only lead to risk and return avoidance.

"You can avoid risk by buying Treasury bills or putting your money into government-insured deposits, but there's a reason why the returns on these are generally the lowest available in the investment world. Why should you be well paid for parting with your money for a while if you're sure to get it back?"

According to him, risk control is declining to take risks that a) exceed the magnitude of risk you want and b) the reward for bearing the risk is low.

Not all investments are good investments
Marks states that while investing, making a few wrong decisions is unavoidable. Investors can only claim to make the right decisions sometimes. Hence, the selection of a few losers is inevitable. The question isn't whether you will have losers, but rather how many and how poor relative to your winners.

He says, "Warren Buffett - arguably the investor with the best long-term record (and certainly the longest long-term record) - is widely described as having had only twelve great winners in his career. His partner Charlie Munger told me the vast majority of his wealth came not from twelve winners but only four. I believe the ingredients of Warren's and Charlie's great performance are simple: (a) a lot of investments in which they did decently, (b) a relatively small number of big winners that they invested in heavily and held for decades, and (c) relatively few big losers. No one should expect to have - or expect their money managers to have - all big winners and no losers."

Is it possible to beat the market?
Marks firmly believes there are times when the markets are either overpriced or underpriced. The efficient market hypothesis does not always prevail because of shifting market sentiments. He argues that the potential skills to generate alpha over the market exist in some markets and with a few investors.

He expresses that investors can produce alpha by reducing the risk while giving up less or increasing potential return by taking moderate additional risk. According to Marks, "The choice between these approaches depends on the type of alpha an investor possesses: Is it the ability to produce stunning returns with tolerable risk, or the ability to produce good returns with minimal risk? Almost no investors possess both forms of alpha, and most possess neither."

Summing up
Risk is unavoidable when it comes to investing. However, Marks, with his years of experience and wisdom, shares how an investor can navigate risks by avoiding losses and, as a result, construct a winning portfolio.

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