Thursday, June 11, 2015

"Risk Means More Things Can Happen Than Will Happen"

The title of this post is a comment originally made by Elroy Dimson, a professor at the London Business School, and recently shared further by Howard Marks of Oaktree Capital.  Mr.  Mark's market commentaries are always a must read for us and his June 8th letter, Risk Revisited Again, is no different.  We definitely recommend it to you as well.

While Mr. Marks and his team at Oaktree primarily operate in an entirely different wing of the investment world (fixed income), we share very similar rules and philosophies when it comes to risk controls.  His letter comes at a good time as another note that recently hit our inbox touched on the topic of risk in a way that struck a chord with us.  Peter Brandt posted some quick comments on his experience with drawdowns during his 5+ decades in the business and how he has come to approach them.  To summarize Mr. Brandt's piece, he essentially says that a trader that intends to survive in the business must learn to accept, expect, and even appreciate drawdowns.  They are a fact of life and one must learn to take them in stride.  It's such a simple concept but so many investors, both professional and retail, for whatever reason (pride, greed, temperament, etc) fail to adequately address risk.

Today, we finally had the opportunity to read Mr. Marks' 20-pages of commentary and it (and Mr. Brandt) compelled us to once again post on the topic of risk.  We've compiled some of our favorite Howard-ism's from the letter and shared them below:

  • The more risk we take because we believe the environment is low-risk in character, the less the environment continues to be low-risk in character.
  • How can investors deal with the limitations on their ability to know the future? The answer lies in the fact that not being able to know the future doesn't mean we can't deal with it.
  • The future should be viewed not as a fixed outcome that's destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.
  • Many possibilities exist today...this uncertainty as to which of the possibilities will occur is the source of risk in investing.
  • It's not reasonable to expect highly superior returns without bearing some incremental risk.
  • While I don't think volatility and risk are the short run, it can be very hard to differentiate between a downward fluctuation and permanent loss.
  • Thinking risk control is easy is perhaps the greatest trap in investing, since excessive confidence that they have risk under control can make investors do very risky things.
  • The key prerequisites for risk control also include humility, lack of hubris, and knowing what you don't know.
  • Risk avoidance isn't an appropriate goal.  The reason is simple: risk avoidance usually goes hand-in-hand with return avoidance.  While you shouldn't expect to make money just for bearing risk, you also shouldn't expect to make money without bearing risk.
  • It's the job of investors to strike a proper balance between offense and defense, and between worrying about losing money and worrying about missing opportunity.  Today I feel it's important to pay more attention to loss prevention than to the pursuit of gain.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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