Oaktree Capital founder Howard Marks (Trades, Portfolio) has written extensively about the risk-reward paradigm, most notably about how to view this dynamic in market conditions where everybody is making money.
Marks believes there are periods in financial history when the risk-gain tradeoff can appear skewed due to mispricing of assets in an environment of historically unprecedented low interest rates.
In his 2017 memo to clients, Marks discussed this phenomenon within the context of the current decade-long bull market, which many investors have come to view as never-ending.
How do defensive investors assess risk in an environment where market participants for the past 10 years have been amply rewarded for holding risky assets for the duration of the near zero-interest rate investment climate that continues to prevail?
Marks suggested that intelligent investors need to avoid complacency and be mindful of how to view the likelihood of losses in such a seemingly care-free and minimal risk environment.
He also noted that even though no two investment market cycles are alike, common themes can be discerned. Warren Buffett (Trades, Portfolio) calls these reoccurring traits “pattern recognition.” Marks cited Mark Twain’s comment that, “History doesn’t repeat, but it does rhyme.” The guru also wrote:
“The duration, pace, amplitude and details of each investment cycle are different from those of its predecessors, but the basic themes and essential ingredients are usually vaguely familiar.”
Marks believes that because everyone currently has not experienced losses in the market, far too many individuals have been inattentive to genuine and potentially unforeseen investment risks that, although improbable, nonetheless need to be considered in order to make fully informed investment decisions.
What is the best way to guard against an unexpected turn of events in a period of market excess?
Marks noted that common mistakes investors make are repetitious, and include the following:
- Awareness of history.
- Belief in cycles rather than unabated, unidirectional trends.
- Skepticism regarding the free lunch.
- Insistence on low purchase prices that provide lots of room for error.
Marks reiterated one of the key and enduring principles of value investing, first articulated years ago by Benjamin Graham:
“Adherence to these things – all parts of the canon of defensive investing – invariably will cause you to miss the most exciting part of bull markets, when trends reach irrational extremes and prices go from fair to excessive. But they’ll also make you a long-term survivor. I can’t help thinking that’s a prerequisite for investment success.”
Marks offered a risk awareness checklist that contains a number of pertinent questions astute investors should ask even when market euphoria prevails:
- Are prospective returns adequate?
- Are investors appropriately risk-averse?
- Are they applying skepticism and discipline?
- Are they demanding sufficient risk premiums?
- Are valuations reasonable relative to historic standards?
- Are deal structures fair to investors?
- Are investors declining any of the new deals?
- Are there limits on faith in the future?
Marks is a firm believer in Seth Klarman’s margin of safety principle of investing, an essential component of which is the knowledge that successful investing frequently entails swimming against the Wall Street tide:
“The basic proposition is simple: Investors make the most and the safest money when they do things other people don’t want to do. But when investors are unworried and glad to make risky investments (or worried but investing anyway, because the low-risk alternatives are unappealing), asset prices will be high, risk premiums will be low, and markets will be risky.
That’s what happens when there’s too much money and too little fear.”
Marks noted that those investors who have taken adequate defensive measures for preservation of capital may do one of several things:
“… (a) lag in terms of return and (b) look like an old fogey. But neither of those is much of a price to pay if it means keeping your head (and capital) when others eventually lose theirs.”
Those investors who follow Marks’ risk awareness checklist for establishing a margin of safety will not generate astronomical returns during a roaring bull market, but they will be poised to profit disproportionately when the panic selling ensues.