Value Investor Daily #51

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Warren Buffett once said, "When I see memos from Howard Marks in my mail, they're the first thing I open and read. I always learn something."

Howard Marks, legendary investor and co-founder of Oaktree Capital, has a unique and nuanced approach to risk.

In this issue, we break down the key insights from his recently released presentation, “How to Think About Risk.”

Watch the lecture if you have the time; it’s an absolute masterclass:

Here’s what we learned:

1. Risk is the true measure of an investor’s skill level

Many investors focus solely on returns, but as Marks explains, returns alone don’t tell you the whole story. The critical question is: How much risk was taken to achieve that return?

Marks outlines different investor scenarios. One manager achieves a 20% return when the market is up 10% but loses 20% when the market is down 10%. This isn’t skill—it’s just taking on excessive risk.

On the other hand, a superior investor might gain 15% when the market rises by 10% and only lose 5% when the market drops 10%. This is value-added asymmetry—outperforming in good times and limiting losses in bad times.

True investing skill is reflected in the ability to manage and control risk, not just chase high returns.

2. Risk is NOT simply volatility

Marks challenged the academic notion that volatility is synonymous with risk. He argues that risk is the possibility of loss, not the fluctuation of prices.

At his firm, Oaktree, no one says, “Let’s avoid this investment because it might be volatile.” Instead, they assess whether the possibility of loss is too high.

Volatility may signal the presence of risk, but it’s not the risk itself. Always assess the potential for actual financial loss.

3. Risk is unquantifiable in advance—and even after the fact

Marks shared a powerful insight: risk cannot be measured or predicted precisely, even after the outcome is known.

You buy an asset for $1 and sell it a year later for $2. Was it a safe investment? Or were you just lucky? You can’t determine whether the investment was inherently risky based solely on the outcome.

The result of an investment doesn’t always reflect the level of risk that was present. A positive outcome doesn’t mean there wasn’t significant risk involved. There’s no 20/20 hindsight with risk.

4. Risk is counterintuitive

Marks highlighted the perversity of risk: often, the riskiest investments seem the safest because overconfident investors have bid up their prices, and people love to see rising prices.

At the same time, investors fear falling prices, but overall risk also falls when prices trend lower. Quite simply, there’s less downside once the worst has already happened. There’s still risk, but it’s not as much as before once the stock has already fallen 80%, especially if the risk of bankruptcy is low.

In the late 1960s, investors poured money into the “Nifty Fifty”—America's 50 most prestigious companies. They believed that these companies were so high-quality that nothing bad could happen.

The stocks reached unsustainable valuations. Many of those stocks fell over 90% in value during the subsequent market decline because they had been priced far too high.

Even high-quality companies can indeed become risky when their prices are too high. Conversely, lower-quality assets can be safe if bought at the right price.

5. The hidden nature of risk

Risk is often hidden, only revealing itself in times of market stress. “It’s only when the tide goes out that we find out who’s been swimming naked,” Warren Buffett says.

In California, homes may contain construction flaws, but those flaws only become apparent during an earthquake. Similarly, an investment might look stable for years until an economic shock exposes its underlying fragilities.

Risk management is critical even when the market seems stable. Your portfolio's flaws are only revealed during crises, and you never know when the next one will hit.

6. Tail events – expect the unexpected

The most important events in financial history have occurred outside of what’s considered “normal” risk. These low-probability, high-impact events—often called tail events or Black Swans—can drastically alter outcomes.

96% of financial history has occurred within two standard deviations, but everything interesting (like the 2008 financial crisis) has happened outside of those boundaries.

Always prepare for the possibility of unexpected, extreme events. History is shaped by anomalies, not by the norm.

7. Intelligent risk management is like insuring your car

Just like we insure our cars in case of accidents, investors must manage risk to prepare for market downturns.

Surprisingly, removing traffic lights and signs in Drachten, Holland, reduced accidents because it forced drivers to be more cautious.

Similarly, investors can save themselves a lot of heartache by staying vigilant. You must always think about the risks in your portfolio.

The best investors manage risk continuously, not just in “risky markets.” Having a disciplined approach to risk is like having insurance—you won’t always need it, but when you do, it’s invaluable.

8. The fallacy of expected value

There are limitations to making decisions based solely on expected value, especially regarding risk.

Imagine you have four possible outcomes in a drawing: 2, 4, 6, and 8. Each is equally likely, so the expected value is 5. But in reality, the number 5 isn’t even one of the possible outcomes—it can’t happen.

Similarly, just because an investment has a high expected value doesn’t always mean it’s the right choice. If some possible outcomes are unacceptable, like losing all your money, it’s not worth the risk. Always avoid the risk of ruin.

Don’t focus purely on expected value—consider the potential downsides, even if they’re improbable. Making a lower expected value bet with a less harmful worst-case scenario is okay.

9. Asymmetry – the cornerstone of superior investing

Successful investing means assembling a portfolio that produces good returns in good times and resists losses in bad times. This asymmetry—capturing more upside while protecting the downside—is the hallmark of superior investors.

Many investors fail to grasp this concept, focusing instead on taking more risk to chase higher returns without adequately protecting against potential losses. It’s extremely common. It’s fundamental human nature. Watch for it in yourself.

Aim for asymmetry in your portfolio—participate in market gains but limit exposure to downturns. Superior investors consistently outperform over many market cycles by doing this.

How can you apply these lessons today?

Look at your portfolio right now and ask yourself these questions:

• Do I understand the risk of each of these assets?

• What’s the worst-case downside scenario? What will I do to avoid it?

• What’s the upside? Is it asymmetrically more than the downside? Am I making 3% (or more) for every 1% of my portfolio that I’m risking?

• If the market turns down, will my portfolio go down more or less than the market?

• If I’m selling at a loss, am I just simply selling at a normal market pullback that will result in a permanent loss of upside? Will the business survive this pullback and ultimately keep growing?

• Are any of these assets glaringly overpriced? Are they at risk of a major drawdown?

• Do my companies have actual cashflows today? Or are they trading based solely on future potential?

• Are there any positions in which I’m getting little to no compensation or upside potential for the level of downside risk I’m taking?

• What if the economy turns south and there’s a recession? Will this company survive? Will customers still need their products and services in a recession? What’s the chance of bankruptcy?

• What’s the chance the company’s moat will be broken by regulation, competition, or disruptive innovation?

• What is the chance of ruin? What’s the possibility of total loss of capital?

• What’s the Altman Z-Score of these stocks? Is it at least above 1.8, and more preferably, is it higher than 3?

• Can the company cover its debt payments if interest rates rise? What’s the current coverage ratio? What’s the debt-to-equity ratio? What’s the debt-to-free-cash-flow ratio?

• How can I better control risk in my portfolio right now, and how can I control it every day, week, and month going forward?

Risk is complex, often hidden, and counterintuitive. The key to long-term success is not avoiding risk but managing it intelligently.

Focus on protecting against loss while capturing upside potential—this is the essence of superior investing.

Thank you for reading today’s newsletter! We hope Howard Marks's wisdom helps you navigate your investments more thoughtfully.

All your news. None of the bias.

Be the smartest person in the room by reading 1440! Dive into 1440, where 3.5 million readers find their daily, fact-based news fix. We navigate through 100+ sources to deliver a comprehensive roundup from every corner of the internet – politics, global events, business, and culture, all in a quick, 5-minute newsletter. It's completely free and devoid of bias or political influence, ensuring you get the facts straight.

Subscribe to 1440 today.