How to Think About Risk: Lessons from Howard Marks

Howard Marks, co-chairman of Oaktree Capital, is one of the clearest thinkers on the subject of risk in investing. His video course "How to Think About Risk" distills decades of experience into ideas that every investor and trader should internalize. Here are the key takeaways.

Risk Is the Ultimate Test of Skill

Return alone tells you nothing about how good an investor is. You have to ask: how much risk did they take to get that return?

Marks lays this out with a simple framework. Imagine the market goes up 10% or down 10%. Now look at different managers:

• Manager A: Up 10 / Down 10. Just an index fund. No skill.
• Manager B: Up 20 / Down 20. No skill either, just aggressiveness.
• Manager C: Up 5 / Down 5. No skill, just defensiveness.
• Manager D: Up 15 / Down 10. Now we're talking. Market-type losses but superior gains. This is asymmetry. This is value added.
• Manager E: Up 10 / Down 5. Market-type gains in good times, but less pain in bad times. This is what Marks says characterizes Oaktree.

The goal isn't to beat the market when it's rising. Performing with the market when it does well is good enough. The real skill is declining less when things go wrong.

Risk Is Not Volatility

The academics at the University of Chicago adopted volatility as the measure of risk in the 1960s. Marks believes they did so because volatility is quantifiable and nothing else is. But volatility is a symptom, not the disease.

Risk, in the real-world sense, is the probability of loss.

Nobody at Oaktree says "we shouldn't make that investment because it might be volatile." They say "the possibility of loss is too high" or "we need a higher return to compensate for the possibility of loss."

Risk Cannot Be Quantified

Risk is not measurable in advance. It's a matter of opinion about the future. But here's the deeper insight: risk is also unquantifiable after the fact.

You buy something for $1 and sell it for $2. Was it risky? You genuinely cannot tell from the outcome. Was it a safe investment that was sure to double? Or a risky one where you got lucky? The outcome alone doesn't reveal which it was.

The Many Faces of Risk

The probability of permanent loss is the obvious risk. But there are others:

• The risk of missing opportunities — not taking enough risk.
• The risk of being forced out at the bottom — selling at the low and missing the recovery. Marks calls this the cardinal sin of investing. If you buy at a high and decline, the next high is usually higher. But if you sell at the bottom, you've gotten off the track and may never get back on.

The Nature of Uncertainty

Peter Bernstein, one of Marks' intellectual heroes, put it this way: "Risk says we don't know what's going to happen. We walk every moment into the unknown."

And then there's the G.K. Chesterton quote that Marks considers essential:

"The real trouble with this world of ours is not that it is an unreasonable world, or even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is. Its exactitude is obvious, but its inexactitude is hidden. Its wildness lies in wait."

We know what's likely. We know what could happen. We have almost no appreciation for the things that are highly unlikely but possible. That's where 96% of financial history occurs within two standard deviations, but everything interesting happens outside of them.

Four Principles for Thinking About Risk

1. More things can happen than will happen. For any future event, there's a range of possibilities. We don't know which one will materialize.

2. The future is a probability distribution, not a single outcome. Don't think of the future as one thing that will happen. Think of it as the most likely, the less likely, and the unlikely-but-not-impossible.

3. Knowing the probabilities doesn't mean knowing the outcome. Even with perfect probability knowledge (like dice), you still don't know what will happen next. As a professor at Wharton told Marks: "We live in the sample, not the universe." Or as a football analyst said before the 2016 Super Bowl: "Carolina wins eight times out of ten. This could be one of the two."

4. Expected value can be irrelevant. If four outcomes are 2, 4, 6, and 8, the expected value is 5 — but 5 can't happen. Worse, even if course A has a higher expected value than B, course A might include a possibility of total ruin. You'd rationally choose B.

Risk Is Counterintuitive and Perverse

In Drachten, Holland, they removed all traffic lights, signs, and road markings. Accidents went down. People drove more carefully. Meanwhile, better climbing gear gets invented every year, yet climbing fatalities don't decrease — people do riskier things because they feel safer.

The risk of an activity doesn't just lie in the activity itself. It lies in how participants approach it. If people conclude a market has become safer, they do riskier things, which makes the market more dangerous.

This is the perversity of risk:

• The riskiest thing in the world is the belief that there's no risk.
• When people say something is risky and act cautiously, it becomes safer.
• As an asset falls in price, people say it's risky — but it's actually becoming less risky.
• As an asset rises in price, people say it's great — but it's becoming more risky.

Risk Is Hidden and Deceptive

Loss happens when risk collides with negative events. As Buffett says, "It's only when the tide goes out that you find out who's been swimming naked."

Like a house in California with a construction flaw — the flaw sits there harmlessly for years until the earthquake hits. An investment can be risky but look safe for a long time simply because the bad event hasn't happened yet. The infrequency of loss makes things appear safer than they are.

It's Not What You Buy, It's What You Pay

This is perhaps Marks' most important lesson. Risk is not a function of asset quality.

In 1969, banks invested in the "Nifty Fifty" — the 50 best companies in America, so good that "nothing bad could ever happen" and "no price was too high." If you bought them in September 1969 and held for five years, you lost over 90% of your money.

When Marks moved to high-yield bonds in 1978 — the lowest quality public companies — he made money steadily and safely.

Investment success doesn't come from buying good things. It comes from buying things well. No asset is so good it can't become overpriced and dangerous. Very few assets are so bad they can't be cheap enough to be attractive.

The Real Risk-Return Relationship

The classic chart shows an upward-sloping line: more risk, more return. Most people read this as "take more risk to make more money." Marks thinks that's terrible.

If riskier assets reliably produced higher returns, they wouldn't be risky.

What the line actually means: investments perceived as risky must appear to offer higher returns to attract capital. But they don't have to deliver. That's where the risk comes from.

Marks improved the chart by overlaying bell-curve distributions along the line. As you move to higher risk, the expected return increases, but the range of possible outcomes widens and the worst outcomes get much worse. That's the real picture.

Risk Management Is Constant

Risk should be dealt with continuously, not sporadically. Marks bristles at "risk on / risk off" thinking.

The right model isn't American football, where offense and defense alternate in clean stoppages. It's soccer — the same 11 people play the whole game, nobody tells you when to attack or defend, and there are almost no breaks to adjust.

The best model is car insurance. You have it every year. You don't regret it at the end of a year without an accident. You value the safety regardless.

The Intelligent Bearing of Risk

When asked how he could invest in high-yield bonds knowing some would go bankrupt, Marks answered: "How can life insurance companies insure people's lives when they know they're all going to die?"

Life insurance companies: (1) take a risk they're aware of, (2) analyze it, (3) diversify it, and (4) get well paid to bear it. That's exactly what intelligent investors do.

The Bottom Line

You shouldn't expect to make money without bearing risk. You shouldn't expect to make money just for bearing risk. Risk is best handled through subjective judgment by experienced investors who emphasize risk consciousness.

Superior investors assemble portfolios that produce good returns when things go as expected and resist declines when they don't. This asymmetry — participating in gains while avoiding many losses — is the cornerstone of great investing.

Risk control is indispensable. Risk avoidance is not. As Will Rogers said: "You've got to go out on a limb sometimes, because that's where the fruit is."

This post summarizes Howard Marks' video course "How to Think About Risk", published by Oaktree Capital.