“I went to business school to learn how be a good investor. When I got to Harvard Business School and I opened the course catalog for the first time and discovered there wasn’t a class on investing, I decided I had to open my first self-study program.”
Hedge Fund Manager Bill Ackman
Why do people study finance, economics or anything related to it? There probably is a variety of reasons for a variety of people, but if one’s motivation is to learn about financial markets and investing, it will not take them long to realise that there can be large gaps between the definitions and significance of theoretical concepts in academia and their meaning in practice.
Famous examples are controversies about the efficient market hypothesis, which in its strongest form has been disproved by the market many times, and the rationality of market participants, which remains one of the key assumptions of modern economics. Over the years, many of the greatest investors have shared their views of investment theories and finance concepts, and they often differ from the academic point of view.
This series of articles will present some of those ideas. This first article talks about risk. Most of one’s (current) understanding of risk stems from Howard Marks’s book “The Most Important Thing“, which provides a range of insights on investment theories that are often not in line with the academic interpretation of them.
Academia vs. Marks – What Is Risk?
According to Marks, the definition of risk taught at universities, namely that risk equals volatility, is wrong, or at least misleading. In his opinion, risk has many components, with the most significant one being the risk of capital loss. Volatility, in Marks’s view, is of minor importance for most investors. Marks adds that academia suggests that with higher risks (i.e. higher volatility), investors will achieve higher returns, which is expressed by the capital market line graph.
But when one thinks about it: if this was always true, then risk would not be risky. Marks expands the capital market line graph by adding that with increasing risk the range of possible outcomes also widens significantly, while the below-expected outcomes become worse in their extent. This is quite intuitive and much more relatable than volatility as the main risk for market participants.
Volatility Decreases Compounded Returns
Before going on to further outline Marks’s views on risk, one will shortly outline why volatility – despite its fallibility – can justifiably be used as a risk measure. This is mainly due to its impact on compounded returns over time. Ed Easterling from Crestmont Research has provided an interesting example showing this:
First, it is important to understand the difference between simple average returns and compounded returns. Simple average returns are just the returns over a number of years (e.g. 10%, 15%, 20%) divided by the number of years (e.g. three years). With the figures chosen below, the simple average return is 15%. The compounded return works slightly differently. To calculate the compounded return with the same figures, one looks at the overall return after the three years:
1.10 * 1.15 * 1.20 = 1.518 (+51.8%)
If one wanted to express the result of 1.518 in equal yearly returns, this would give them 1.1493, i.e. 14.93% annual compounded return. (1.1493 * 1.1493 * 1.1493 = 1.518).
So far, so good. What’s the point? The point is that if one were to increase the volatility of the annual returns, say the years were 0%, 15%, 30%, one’s compounded return would decrease to 14.3%. In other words, while on average one achieved the same returns whether they were 0%, 15%, 30% or 10%, 15%, 20%, the compounded return decreases with increased volatility of the returns. The compounded return can be viewed as the more significant one compared to the simple average, as it represents the income one can actually spend. The simple average is just a number that does not say that much after all.
In short, limiting volatility in one’s portfolio increases compounded returns over time. Nevertheless, Marks maintains that volatility is of minor importance to most investors, reminding people that “if higher risk always meant higher returns, then risk would not be risky“. It is the risk of capital loss that ought to be seen as most significant to investors.
Subjectivity of Risk
Apart from the most significant risk of capital loss, there are other risks that Marks names, some of which are highly subjective as they apply to some investors, while not applying to others. Examples of those are illiquidity risk (risk of turning an investment into cash at a reasonable price), underperformance risk (benchmark risk), career risk (an extreme form of underperformance risk) and so on. As mentioned before, what is striking about those types of risk is their subjectivity. Marks even goes as far as to claim that “risk is largely a matter of opinion“.
Risk Is Hard to Measure
According to Marks, much of investment risk is hidden, subjective, and unquantifiable. Despite this, there is still a certain amount of risk that is quantifiable. The question remains how to quantify this risk in practice. This is where another one of Marks’s criticisms comes in. He explains that risk evaluation is often based on the expectation of usual (known) patterns to repeat. The problem: they do not always repeat.
The extent of the stock market and housing price crash during the Great Recession provides a good example for the validity of the old saying that “nothing ever happens until it happens for the first time“ (another author that examined the issue of (mis)judging the risk of the highly unlikely is Nassim Taleb, who wrote the book about so-called “Black Swan“ events). The academic approach of using specific risk-adjusted performance measures like the Sharpe Ratio (excess return over volatility), in Marks’s view, is only applicable to certain publicly traded assets. It is, however, not applicable to private assets (private companies, real estate).
Academia actually does recognise the fallibility of their ratios, however for different reasons (for example asking if upside volatility should be counted as equally undesirable as downside volatility). Theorists have therefore come up with alternatives like the Appraisal Ratio or the Treynor Measure, which are applied depending on how diversified a portfolio is when measured.
Marks adds to his analysis of risk that it is not only hard to measure before a risky event in question could occur, but even after it has already done so. Think about this: The weatherman tells us there is a 70% chance that it will rain the next day. Then it rains. Was he right or wrong? In other words, even after a particular risk event has occurred, it often remains impossible to say whether or not an evaluation of that risk has been correct. To put it another way: absence of loss does not mean there was no risk.
This has to influence our understanding of investors’ performance evaluation. One of the conclusions from the difficulty of assessing risk even after it has occurred is that fund manager performance can only be reasonably assessed in the long-term. In a cyclical bull market, those investors who take the highest risk will outperform, but one cannot know how often they were “right for the wrong reasons“. Therefore, a long-term risk-adjusted measure of performance needs to be applied to accurately assess investment performance. Marks says that “achieving a given return with lower risk is true skill“ and adds Warren Buffet’s quote:
“Only when the tide goes out do you discover who’s been swimming naked“.
Marks seems to be a general fan of quotes – his favourite one on the definition of risk is that “risk is if more things can happen than will happen“. For everyone who plays poker or any sort of game where the probabilities are well known: it still happens frequently that improbable events occur. And that is in a setup where all the probabilities are always known to the skilful players. Now, in the market, where very few outcomes have an exact probability attached, it should be even harder to quantify risk-evaluation.
How Does Risk of Capital Loss Emerge?
An important lesson to take away from Marks’s thoughts on risk is what actually triggers it. Marks says that capital loss can occur without fundamental or macro weakness, but solely through the “arrogance of investors and their non-understanding of risk“. He goes on to explain that risk of capital loss is particularly high when assets are overpriced.
His view is that overpricing mainly stems from irrational herd behaviour when most investors expect high returns from “popular“ assets that have been doing well lately. Hence the risk does not come from any external factors but is inherent in the behaviour of the market participants. This is one of the most interesting ideas about the concept of investment risk and leads to the second part about understanding risk: who or what creates investment risk? To be continued.