Taking stock of risk
When markets take a tumble like we have seen across the equity world over the last few days, it’s usually the time investors reassess their view on risk! Booms, busts, stress and joy are driven by emotions and hence many investors have outsourced all or part of their investments to advisers or fund managers who are very risk aware and hopefully have risk at the forefront of their minds.
At Montgomery we have a good amount of flexibility in attempting to preserve capital for investors through our ability to hold cash, and more of it than most funds or our ability to short stocks through our Montaka and Montgomery Alpha Plus funds. For those that follow our commentary closely, you may be aware that we have had elevated levels of cash for some time now and while it can be uncomfortable not to be fully invested in equities when stock prices are going vertical, a measured approach to risk and return are required. Risk management is always at the forefront of the Montgomery investment team’s thinking and this recent volatility provides us the opportunity to assess opportunities in the broad-based sell off, which can be quite undiscerning of the merits of the individual companies. Cash provides us the “dry powder” to pounce on these opportunities.
Thinking about risk and how to manage it today, one of the best-known investors in the global investment community is Howard Marks, the founder of Oaktree Capital who manage US$90 billion. His “Oaktree memos’ are regarded as some of the most insightful thinking on markets, economies and the assessment of risk for investors. I have selected some of his most pertinent observations on risk below:
The Ultimate Test of Investment Skill
- It’s not hard to achieve investment return.
- That’s especially true when the market rises, which it usually does.
- The real achievement is achieving return with risk under control.
- The key questions when you see a portfolio perform well:
- Is it just a fair-weather portfolio?
- How will it hold up if the environment turns hostile?
The Likelihood of Being Forced Out at the Bottom
- Many investors claim to be long-term oriented and thus immune to fluctuations.
- But bad-enough declines can make them sell:
- because they lose confidence
- because they receive margin calls or
- because of a need to fund real-world cash requirements.
- Some of the greatest pain in 2008 was felt by investors who had overestimated their ability to withstand volatility.
- Selling at the bottom – and turning a downward fluctuation into a permanent loss – is the cardinal sin in investing.
An Essential Consideration in Assessing Investment Performance
- Return alone tells only part of the story about performance.
- Two investors with the same return didn’t necessarily do equally good jobs.
- Their performance has to be viewed in risk-adjusted terms.
- The key question is “How much risk did each one bear?”
- Academics developing investment theory accepted volatility as the measure of risk. I believe they did this in large part because volatility is readily quantifiable.
- However, few people in the real world consider volatility the key risk, but rather the permanent loss of capital.
- Risk premiums aren’t demanded in response to volatility.
- Only volatility is fully quantifiable.
- Nothing can be substituted for volatility in investment theory’s calculations.
- But volatility alone isn’t a useful measure of risk.
Unquantifiable In Advance
- Like any judgment regarding the future, the probability of loss can’t be anything but a matter of opinion.
- A variety of experts will view it and quantify it differently.
Unquantifiable After the Fact
- A profitable investment may (or may not) have been risky.
- Was it a safe investment that was sure to produce a positive outcome?
- Or was it a risky investment where the investor got lucky?
- Likewise, a losing investment may not have been risky, just unlucky.
- For the outcome of an investment to be an accurate indicator of its riskiness, return would have to be a function of risk alone. There are too many factors at play for that to be the case.
- The bottom line: it’s impossible to quantify risk, even in hindsight.
- Thus, in particular, it’s impossible to say high-returning portfolios were riskier and low-returning portfolios were safer. In fact, the opposite is often true.
Best Assessed through Subjective Judgment
- Since risk can’t be measured, gauging it has to be the province of experts.
- Imprecise, qualitative, expert opinion about the probability of loss is far more useful than precise but largely irrelevant numbers concerning volatility.
- When all traffic controls were removed from the town of Drachten, Holland, traffic flow doubled and fatal accidents fell to zero (Dylan Grice, Soc. Gen.).
- “Jill Fredston is a nationally recognized avalanche expert . . . She knows . . . better safety gear can entice climbers to take more risk – making them in fact less safe.” (Pensions & Investments)
- Thus the risk of an activity often lies not in the activity itself, but in how the participants approach it.
- Likewise, the degree of risk present in a market derives more from the behavior of the participants than from the companies, securities and institutions. Risk is low when investors behave prudently and high when they don’t.
- Prior to the subprime crisis, there had never been a nationwide wave of mortgage defaults. This convinced investors that mortgages were safe. This, in turn, led to a lowering of credit standards and the issuance of mortgages so weak that a nationwide wave of defaults was inevitable.
- The riskiest thing in the world is widespread belief that there’s no risk.
- A high level of risk consciousness tends to mitigate risk.
- As an asset declines in price, making people consider it riskier, it becomes less risky.
- As an asset appreciates, making people think more of it, it becomes riskier.
- This perversity is one of the main things that render most people incapable of understanding risk.
Hidden and Thus Deceptive
- Even if it contains construction flaws, a house will stand until there’s an earthquake.
- Equally, an investment can be risky and still not show losses as long as the environment remains salutary.
- The fact that an investment is susceptible to a serious risk that will occur only infrequently – the “improbable disaster” or “black swan” – can make it appear safer than it really is.
- The riskiness of an investment becomes apparent only when the investment is tested.
- “It’s only when the tide goes out that we find out who’s been swimming naked.” –Warren Buffett
Something That Should Be Dealt with Constantly, Not Sporadically
- Risk produces loss when bad things happen; that’s when we need risk control.
- But we never know when bad things will happen, and thus when risk control will be needed.
- The right model for investing isn’t American football, where one team’s defensive squad tries to stop the other’s offensive squad for a while, and then they trade places. The right model is soccer, where pretty much the same eleven people have to play both defense and offense all game, and there are few stoppages or substitutions.
- Likewise, in investing no one tells you when to substitute defense for offense, and there are no stoppages during which to do it.
- Risk control is unnecessary when loss doesn’t occur, but that doesn’t mean it’s a mistake to have it. The best model is automobile insurance: do you regret having had it in a year without an accident?
The Product of Uncertainty Concerning the Future
- “Risk means more things can happen than will happen.” – Elroy Dimson
- It’s challenging to come up with an estimate of an investment’s expected rate of return.
- It can be much harder to comprehend and describe the entire distribution of possible outcomes around the expected return.
The Bottom Line – from Howard Marks
You shouldn’t expect to make money without bearing risk, but you also shouldn’t expect to make money just for bearing risk.
Risk is best handled on the basis of accurate subjective judgments on the part of experienced experts emphasizing risk consciousness.
Outstanding investors are outstanding because they have a superior sense for the probability distribution that governs future events, and for whether the potential returns compensate for the risks that lurk in the distribution’s negative left-hand tail.