One of the most important things in investing is risk management. Howard Marks, co-founder of high-yield bond firm Oaktree Capital Management, believes managing risk is the ultimate test of an investor’s skill.

In this feature we explore the nature of risk, which may surprise you, and reveal how professional money managers like Marks manage it.

It may be comforting to believe your fund manager is achieving returns based on pure skill, but Marks believes it is impossible to know for sure how much risk a manager has taken to deliver a particular return, even after the fact.

This is because risk is often hidden, and at the end of the day a manager may just have been lucky.

SO, WHAT IS RISK?

Boiling it down, risk is the possibility or the odds of incurring a loss. Risk can also be thought of as uncertainty about the future.

Marks does not believe risk can be quantified precisely. The best anyone can hope for is to make an accurate subjective judgment based on expert knowledge, but even then risk cannot be removed entirely.

Nor should anyone want to remove all risk because that too is risky. In other words, counterintuitive as it sounds, not taking enough risk is risky.

One other type of risk Marks believes is important, and the ‘cardinal sin’ of investing, is being forced to sell at the bottom and missing the subsequent upside. This is disastrous risk management.

WHERE DOES RISK COME FROM?

Risk is ignorance of what is going to happen. The problem is, more things can happen than we can ever imagine but only one thing will happen.

This blindness is the source of risk. Imagine you live on the San Andreas fault in California in a modern house with a design flaw. You could live many years in the house without suffering any negative consequences.

It is only when an earthquake happens that the design flaw comes to light, and the loss is experienced. It is when risk collides with negative events that investors suffer loss.

As you might guess, Marks is not a fan of assigning probabilities to things to calculate risk-weighted scores because knowing the probability of something happening does not help pin down what will happen in the end.

Risk can be counterintuitive, and even perverse. When fewer people are worried about risk, that laid-back attitude makes an investment riskier, and the reverse is also true. When investors are very focused on risk, an investment becomes less risky as a result.

Attitudes matter. One study, based in a Dutch town, showed that removing road markings and traffic lights actually led to fewer road accidents because drivers ‘perceived’ there was a greater risk and consequently drove more carefully.

If asked, most of us would say investing in high-quality companies with strong growth prospects sounds like an obvious low-risk strategy.

However, in the late 1960s, long before the market’s current infatuation with the Magnificent Seven, US investors fell in love with another group of stocks which became known as the ‘Nifty Fifty’ ─ a collection of large-caps perceived to be the best and fastest-growing US firms.

Any investor who bought the Nifty Fifty in 1969 and steadfastly held onto them for the next five years would have incurred losses of more than 90%, incredible as it sounds.

The perceived high-quality nature of these companies, which included IBM (IBM:NYSE) and Coca-Cola (KO:NYSE), did nothing to protect investors from heavy losses.

Quite simply, the prices investors were prepared to pay for these high-flying companies were too high and their valuations became unsustainable which made them riskier to own.

THE RISK-RETURN RELATIONSHIP

Studies have shown that riskier assets like stocks have delivered a higher return than bonds, and it is often assumed that this relationship is smooth.

Marks argues this assumption doesn’t help our understanding of the underlying nature of risk.

As investors move up the risk spectrum in search of higher returns, the range of possible outcomes expands, and the worst-case outcomes get more extreme, with potential for losses.

This is a much better way of thinking about the relationship between risk and return, says Marks.

PULLING IT ALL TOGETHER

As we have all experienced, from time to time things turn out differently to what we expect. It is how as investors we prepare for and deal with those eventualities which defines good risk management.

According to Marks, sound risk management is ‘the intelligent bearing of risk for profit’.

Good investors keep risk under control - superior investors assemble diversified portfolios with solid risk controls, allowing for the possibility of gain.

WHAT DOES THIS LOOK LIKE IN PRACTICE?

Imagine the stock market goes up 10% in the good times and falls 10% in the bad times. If investor A’s portfolio goes up 15% in the good times and down 15% in the bad times, there is no value being added, just excessive risk taking.

In other words, investor A captured 1.5 times the market’s upside return but also 1.5 times the downside. The net result is a 2.25% loss (1.15 x 0.85 – 1 x 100) compared with a market loss of 1%. (1.1 x 0.9 -1 x 100)

On the other hand, investor B’s portfolio goes up 10% and down 6%, matching the market gains when times are good but protecting against steep market losses in the bad times.

The net result is a 3.4% gain (1.1 x 0.94 -1 x 100) against a market loss of 1% which shows superior risk management and skill.

Marks believes it is ‘reasonable’ to match the market’s return when it goes up, which itdoes most of the time. The real value-add is providing an element of protection from losses on the way down.

The best permutation is a combination where an investor captures more of the upside and less of the downside, demonstrating strong risk management and true investment skill. This is a rare feat in the investment world. 

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