“The belief of risk being low leads to risk being high.“
This is one of the most important takeaways from Howard Marks’ book “The Most Important Thing“. What he means by this statement is that it is not the quality of a stock (or an asset in general), but its price that constitutes its riskiness. Therefore, risk comes from (or is created by) market participants, not from external or structural factors.
As everyone wants to buy something that has already seen significant upside the risk of that investment rises, as risk is defined as the possibility of losing money on the investment (not volatility!). Basically, the market is riskier if investors generally behave risk-tolerant, and less risky when investors generally behave risk-averse.
Admittedly, this insight is not too surprising. What is more interesting in Marks’ analysis is his take on the reasons for the “remarkable tendency“ of this behaviour (buying when valuations are already up a lot) to reoccur. He sees the roots for this in the belief that external factors influence the riskiness of an asset.
Many financial bubbles share the feature that around the time of their origination there was talk about how some external factor made markets less risky and therefore conventional risk assessing would not apply anymore.
Examples of such external factors have been central banks interfering in the market, computerisation making the markets more efficient or the increasing possibilities to hedge investments. All those factors determine why markets will behave differently this time than they did in similar situations.
Marks compares this thinking to the (inexperienced) climber’s behaviour, who will take more risk when he thinks that his equipment is particularly safe. The risk-is-gone myth remains one of the crucial contributors to bubbles, and the consequences of yet another “this time it’s different“ mentality are one of the most important lessons of 2007.
A Simple Model of Investment Risk
So what exactly are the factors that lead investors to buy overvalued assets? Imagining a market where there is currently no investment risk whatsoever – what has to happen for investments to be risky?
According to Marks’ view of risk, it starts with four basic conditions:
- recent good performance of risky assets;
- easy availability of credit;
- strong capital inflows to the market.
These conditions then lead to “inadequate scepticism“; in other words, investors become less risk-averse than they should be. The fourth condition is low returns on safe-regarded assets, which in turn lead to excessive optimism among investors as many of them have to invest in something.
The combination of excessive optimism and inadequate risk-aversion leads to high prices, which equals investment risk. This model, admittedly, is quite simple.
Despite its simplicity, it provides an interesting breakdown of the major factors leading to asset overvaluation. It is particularly interesting today, as the similarities to today’s market situation are remarkable:
- “Recent good performance of risky assets“ – the world is now going into the 9th year of the current bull market (whether it is a cyclical or a secular bull market according to different theories of cycles, that is for another article);
- “Easy availability of credit“ – (corporate) QE, ultra-low rates;
- “Strong capital inflows to the market“ – QE, corporate buybacks;
- “Low returns on safe-regarded assets“ – historical lows in developed world government bonds.
Summing Up: When Is Risk High?
Marks’ view is that risk-aversion is key for a “sane“ market. The herd is often wrong about risk: assets that have become “unpopular“ and that are considered “too risky to handle“ often provide extraordinary high return potential as the “unpopular“ asset that is deemed too risky goes to a price level where it is actually a relatively “safe“ investment. An example of an asset becoming “unpopular“ and “too risky to handle“ might be that of Greek government bonds.
Overall since the 2012 debt restructuring, returns on Greek government debt are over 200%, according to the Bloomberg Greece Sovereign Bond Index, and some brave hedge funds have profited greatly from that trade.
However, this example might not be what Marks had in mind in his outline of “unpopular assets“ as Greek bonds have actually had a serious risk of default and their survival was dependent on the willingness of external money lenders and still is today. Marks’ ideas relate more to the equity markets, where the default risk is sometimes overstated as a stock becomes unpopular.
However, his point stands. Often, “what everyone thinks is risky, is safe, and vice-versa“. This is because investors believe that risk is about the quality of an asset. However, in Marks’ view, “risk is about the price of an asset, not its quality.“
How to Control Risk?
Marks’ stance on risk is incomplete without his suggestions on how to control risk when defining it according to his explanations. He firstly notes that “the ability to manage risk is widely underrated“. The reasons for this lie in the difficulty to measure risk even after risky events have occurred, as discussed before. Risk, namely the possibility of loss, is unobservable, and hence the managing of it is too. So how to intelligently bear risk?
To outline his view on effective risk control, Marks employs a comparison to the business of life insurers. (Well-managed) Life insurers make money even though eventually everyone is going to die. How do they do that? The answer is a deep awareness of the risks. Life insurers’ risks are:
- Analysable. There are statistical tables on life expectancy, which allow for accurate probability estimates;
- Diversifiable. Even if a couple of people diverge from the statistical life expectancy, the number of people insured by such policies gives the insurers a high diversification in their “portfolio“;
- Well paid for. Premia are calculated according to actuarial tables, and in a way that the insurer will make money if things go as expected. If the insurance market is not entirely efficient, this means that life insurers can sell policies that pay off if someone dies at 80, even when his life expectancy is only 70. To some extent, this “market“ is comparable to some of the less efficient financial markets, for example, the high yield bond market.
A key point to note from this understanding of managing risk is that risk control does not mean risk avoidance.
“Skilful risk control is the mark of the superior investor.”