Why investors need to reconsider what ‘risk’ really means
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Howard Marks, the chairman of Oaktree Capital Management in L.A., suggests that a change in investing terminology might be a good idea after the horrendous losses investors faced in the 2008 and early-2009 market meltdowns.
He writes in his latest letter to clients:
’ ‘Risk’ has become such an everyday word that it sounds harmless -- as in ‘the risk of underperformance’ and ‘risk-adjusted performance.’ Maybe we should switch to ‘danger’ to remind people what’s really involved.’
I think he’s on to something -- because the statement, ‘I want to reduce the risk in my portfolio’ really does mean ‘I want to reduce the danger in my portfolio.’
Marks, a veteran money manager who is well-known on Wall Street for his periodic essays on big-picture issues in the economy and finance, focuses in his latest letter on how investing practices ‘went off the rails’ in the years leading up to the credit crisis and subsequent market crash.
Reaching into now-distant history, he laments that the 1990s bull market pulled so many Americans into the equity market in a huge way.
‘It’s interesting to consider whether this ‘democratization’ of investing represented progress, because in things requiring special skill, it’s not necessarily a plus when people conclude they can do them unaided. The popularization -- with a big push from brokerage firms looking for business and media hungry for customers -- was based on success stories, and it convinced people that ‘anyone can do it.’ Not only did this overstate the ease of investing, but it also vastly understated the danger.’
Marks also decries the more recent rise of ‘black box’ investing -- i.e., leaving ‘buy’ and ‘sell’ decisions up to computer models:
‘Many of the investment techniques that were embraced in 2003-07 represented quantitative innovations, and people seemed to think of that as an advantage rather than a source of potential risk. Investors were attracted to black-box quant funds, highly levered mortgage securities critically dependent on computer models, alchemical portable alpha, and risk management based on sketchy historical data. The dependability of these things was shaky, but the risks were glossed over. ‘I’ve often argued that the key to successful investing lies in subjective judgments made by experienced, insightful professionals, not machinable processes, decision rules and algorithms. I love the way Einstein put it: ‘Not everything that can be counted counts, and not everything that counts can be counted.’ ‘
-- Tom Petruno