Original subtitles

hi I'm Howard marks and this is how to

think about

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risk the title of this class is how to

think about risk that's an important

title not what to think how to think the

first question is what is risk risk in

my opinion is the ultimate test of an

Investor's skill the return alone

doesn't tell you how good a job the

manager did the key question is you see

the return you must ask how much risk

did the manager bear to get that return

now let's look at this range of managers

what we posit is that the market is up

10% or down 10% now let's look at some

individual managers the first one is up

10 when the Market's up 10 and down 10

when the Market's down 10 ACC lishes

nothing you might as well have invested

in an index fund that emulates the

performance of the market no skill no

value added now let's look at the second

one up 20 when the market goes up 10

down 20 when the market goes down 10 no

skill no value added just a lot of

aggressiveness what about this one up

five when the Market's up 10 down five

when the Market's down 10 again no

selection ability no discernment no

value added just defensiveness you don't

need help in achieving that and you sure

shouldn't pay a lot for it but what

about the next one he or she is up 15

when the Market's up 10 and down 10 when

the Market's down 10 so in other words

Market type losses on the downside but

Superior gains on the upside value added

what I call asymmetry does better in the

good times than does poorly in the bad

times but what about this one and I

think this is the most interest I think

maybe it characterizes Me Maybe it char

izes oak tree to some extent up 10 when

the Market's up 10 down five when the

Market's down 10 so Market type gains in

the good times I personally think that

performing with the market when it does

well is good enough and that's almost

all the time nobody should have to beat

the market when it does well but if you

can do that and at the same time be

ready to decline less when the market

has it down spells I think that's

accomplishing something very

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important I believe that risk is not

volatility the academics developing

investment Theory largely at the

University of Chicago in the early 60s

just a couple of years before I got

there adopted volatility as their

measure of risk I believe they did so

largely because volatility is readily

quantifiable and nothing else is I think

volatility can be an indicator of the

presence of risk a symptom if you will

but it's not risk itself so if risk is

not volatility then what is it and in my

opinion and in the real world sense risk

is the probability of loss I think this

is what most people mean when they say

risk and I think that this is what

people demand compensation for if

they're going to Bear it uh nobody

sitting around at Oak Tree says well you

know uh we shouldn't make that

investment because it might be volatile

or uh because it might be volatile we

should demand a higher return no they

say that about the possibility of loss

we're not going to make that investment

because the possibility of loss is too

high or because of the possibility of

loss we're going to demand a risk

premium in terms of the return this is

risk the possibility of loss now another

important question is is risk

quantifiable in advance and I believe

it's not like most things occurring in

the future risk cannot be anything

except a matter of opinion I was writing

my first memo about risk in 2006 I wrote

about my belief that risk is not

quantifiable in advance and then I hit

the return key and went on to the next

section and wrote something I had never

thought about before

my belief that risk is unquantifiable

even after the fact and I think this is

a fascinating topic uh you buy something

for a dollar and a year later you sell

it for $2 was it

risky and the interesting thing is that

you can't tell from the outcome a

profitable investment may or may not

have been risky was it a safe investment

that in the case of my example was sure

to double or was it a risky investment

where you got lucky in terms of the

outcome and as I say you can't tell from

the outcome the bottom line is to me

it's impossible to quantify risk in

advance or even in

hindsight the possibility of loss is not

the only form of risk there are lots of

forms of risk my last memo on the

general subject it's called risk

Revisited again and I talk in there

about 24 or 25 different forms of risk

some serious some facius some important

some less important and obscure but

still it comes in many forms the risk of

missing opportunities is another

important risk in other words if you

think about it the risk of not taking

enough risk another really important

form uh of risk I think one of the key

risks in investing is the chance of

being forced out at the bottom which is

a bigger mistake buying at the high and

seeing a decline or selling out at the

low and missing out on the recovery

clearly it's the ladder if you buy at a

high and you experience a decline if

you're able to hold throughout and not

lose your nerve the next high is usually

higher than the last High the fact that

you experienced a downward fluctuation

might have been uncomfortable for a

little while

but by the time the new high is achieved

you're you're you're back to to your

cost and more but if you sell at the

bottom and miss out on the subsequent

recovery that means you've gotten off

the track of investing and uh may never

get back on in my opinion selling at the

bottom it's the cardinal sin in

investing

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now I want to get a little philosophical

one of my great Heroes Peter Bernstein

probably the best thinker in a

philosophic sense and and a real

investment Sage who sadly passed away

around 2009 one said essentially risk

says we don't know what's going to

happen we walk every moment into the

unknown he said there's a range of

outcomes and we don't know where the

actual outcome is going to fall within

the range and often we don't know what

the range is so in other words we have

ignorance to varying degrees about what

the future holds and it is from this

ignorance uh that risk ensues if we knew

what was going to happen by definition

there would be no risk in the memo that

I mentioned before risk Revisited again

there's a great quote uh that I got from

a Peter Bernstein memo and I thought it

was so important that I took it over

word for word in my memo it's from GK

Chesterton who was a English uh writer

and he said the following and I'm going

to give it to you word for word uh

because it's so important 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 weight in other

words we know what's likely to

happen we know the other things that

probably could happen instead

we have little appreciation for the

things that are highly unlikely to

happen but could and these are what we

call in modern day terms the uh tail

events my friend Rick kanaine once said

that 96% of financial history has

occurred within two standard deviations

but everything interesting has happened

outside of two standard deviations

that's the wild part

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so now let me try in a slightly

philosophical sense to reflect to you

how I think about risk how I think you

might consider risk through four basic

points number one there was a professor

at the London Business School who said

risk means more things can happen then

will happen for most events that lie in

the future there are a number of things

that could occur we don't know which one

it will be that's where the risk comes

in more things can happen then will

happen number two as a result of that

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

because you have some insight into their

respective likelihoods as a probability

distribution the most likely the less

likely the unlikely but not impossible

number three it's important to accept

that even when you know the

probabilities that doesn't mean you know

what's going to happen uh this is uh

something that I think many people fail

to grasp I play a lot of back gamon and

a lot of my examples uh on risk and

uncertainty uh come from the game of

back gamut which is played with a pair

of dice and when you roll your pair of

dice

we know exactly in advance what the

probabilities are each die has six sides

there are 36 possible combinations of

the six sides we know how many of them

for example will add up to seven and

seven is the most likely single outcome

1 16 25 34 43 52 61 there are six

possibilities out of the

36 that will give you a seven that's the

most likely outcome uh six out of 36

that's 16.7% probability now what if

instead you want to know about a six

well with a six there are five

possibilities five possibilities out of

36 that's a little less than a seventh

and then when you get down to uh the

number two is's only one one one one out

of 36 and for the number 12 only one 66

one out of 36 both of those are about a

3% probability of happening so we know

exactly what the probability

distribution looks like uh uh we know

what's the most likely the other likely

possibilities and the unlikely

possibilities we still don't know what's

going to happen so knowing the

probabilities does not eliminate the

uncertainty I work with a professor at

Warden named Chris gsy and the way he

put it to me one time we live in the

sample not the universe in other words

the universe statistics

like I just explained for the dice

determine the things that could happen

and maybe their possibility but we live

in the sample we only have one outcome

and therein lies the uncertainty a great

way to think about this is on Super Bowl

morning in 2016 they had a former

football player on uh and he said what I

thought was one of the smartest things

about uh probability I had ever heard

this game was Denver versus Carolina and

Carolina was heavily favored and they

asked him who he thought would win and

he said the following Carolina wins

eight times out of 10 this could be one

of the two now this gives you the UN the

essence of probability and the essence

of risk uh most people if they hear that

something's 80% likely to happen they

say well then I guess we know what's

going to happen I guess they might might

as well not play the game no 80% likely

means that the other team should win one

game out of five so have to play the

game because we have to figure out which

game this will be and that leads to

number four I take Dimson statement that

uh risk means more things can happen

than will happen and I turn it

over even though many things can happen

only one will thus the expected value

the probability weighted average of the

possible outcomes which is the basis on

which people make uh many decisions it

can be irrelevant they take each outcome

they multiply it by the probability they

add them up and they get the expected

outcome and many people will say well

we're going to take the course of action

that has the highest expected value but

sometimes the expected value isn't even

among the possibilities now this sounds

highly counterintuitive but think about

this let's consider a course of action

which has four possible outcomes 2 4 6

and 8 and let's say that we conclude

that each of those four is equally

likely to happen so what we do is we

take each one 2 4 6 8 we multiply it by

25% the possibility of it happening and

we add it together and in this case the

the expected value of 2 468 is five but

five can can't happen remember I said

the outcomes can be 2 4 6 and eight so

it I'm I'm only going through this to

show you the possible fallacy of

expected value there's another problem

with expected value because even though

course of action a can have a higher

expected value than course of action B

course of action a may include some

possibilities that you just can't live

with maybe course of action a uh

includes some remote possibility that

you lose all youry money and even though

it's highly unlikely you you may say I

just don't want to contemplate that so

you don't take a you take b instead

which has a slightly lower expected

value uh but without the risk of

Ruin now moving on a little bit to to

talk about the character of risk I think

it's interesting to note that risk is

counterintuitive they did an experiment

in the town of draon Holland they took

away all the traffic lights traffic

signs and Road markings what do you

think happened to the level of accidents

and

fatalities it went down how could it

possibly have gone down when all the

road AIDS were gone and the answer is

people said oh there are no more traffic

signs traffic lights or Road markings

I'd better drive more carefully on the

other hand Jill fredson is uh an expert

on a avalanches and uh she said that

better gear is created every year which

makes it easier and more feasible to to

climb and yet the risk the number of

fatalities and accidents in Climbing

doesn't go down how can that be

obviously counterintuitive people see

that better gear is being invented and

they say Well since we have better gear

we can do riskier things and the level

of accidents and fatalities is

maintained even in in spite of the

arrival of better gear so if you think

about those two examples you realize

that the risk of an activity doesn't

just lie in the activity in itself but

importantly in how the participants

approach it the degree of risk present

in a

market or in an investment doesn't come

just from the market or the investment

but how people participate in that

investment and if they conclude that the

market has become safer they may say

that that frees them to do riskier

things and that's why I believe that

risk is low when investors behave

prudently and High when they don't just

as risk is counterintuitive I believe

that risk is perverse as I said the

riskiest thing in the world is the

belief that there's there's no risk a

high level of risk Consciousness on the

other hand tends to mitigate risk so

when people say well that's really risky

if they take a a cautious approach then

it becomes safe as an asset declines in

price most people say oh it's risky look

how it's falling but with the lower

price it actually becomes less risky as

an asset appreciates most people say

that's a great asset look how well it's

doing but the rising price makes it

riskier so again pervert

and this perversity is one of the main

things that render most people incapable

of understanding risk I think it's

important to grasp a concept risk is

hidden and risk is deceptive loss is

what happens when risk the potential for

loss collides with negative events you

know Buffett says everything the

greatest and he said that uh it's only

when the tide goes out that we find out

who's been swimming naked

uh it's only in times of testing that

investors and their strategies uh are

examined uh for the risk they really

held an example of that I wrote in my

book The most important thing uh those

of us who live in California as I did at

the time our houses might contain a

construction flaw but if all is well

that flaw sits there for year after year

and doesn't produce any loss it's only

when the earthquakes occur that the

house is tested and the flaws are

disclosed and the risk the potential for

loss turns into actual loss so similarly

an investment can be risky but if it

only exists in salutary environments it

may look like a winter for a long time

and it may look safe for a long time the

fact that an investment is susceptible

to a risk that occurs extremely rarely

uh what I call an improbable disaster

what Nasim Nicholas TB called The Black

Swan in his excellent book The

infrequency of loss can make it appear

that the investment is safer than it

really is and of course that's an

entirely risky uh conclusion so uh the

infrequency with which uh risk turns

into loss uh can be deceptive uh and

cause people to underrate the risk

involved in an activ

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one of the most important things for

every investor to learn is that risk is

not a function of asset quality this too

sounds counterintuitive there's a belief

that high quality assets are safe and

lowquality assets are risky I believe

quite the opposite a high quality asset

can be priced so high that it's risky I

came to to work in this industry in

September of 1969 the banks at that time

and I was hired by one of them engaged

in what was called nifty50 investing

they invested in what were considered to

be the 50 best and fastest growing

companies in America companies so good

that nothing bad could ever happen and

there was no price too high for their

stocks and if you bought those great

companies the day I got to work in

September of 1969 and if you held their

stocks tenaciously for the next five

years you lost more than 90% of your

money because the prices paid were just

too high and unsustainable and roughly

half of those companies did run into

serious fundamental problems their

quality alone or their perceive quality

did not impart to them the safety that

people thought it would and in fact

because people thought they were so safe

they bid them up to prices which in fact

made them risky on the other hand a

lowquality asset can be cheap enough to

be safe again this seems

counterintuitive and maybe even perverse

when I left the world of equities in

1978 I was asked by City Bank to start

their activity in high yield bonds and

now I was investing in the lowest

quality uh public companies in America

and making money steadily and safely the

ju toos of these events taught me an

important lesson uh that I want to share

sh with you uh so that you don't have to

learn it firsthand my conclusion was

it's not what you buy it's what you pay

and investment success doesn't come from

buying good things but from buying

things well and if you don't know the

difference you have to study up um there

are no assets that are so good that they

can't become overpriced and

dangerous there are very few assets that

are so bad that they can't be cheap

enough to be attractive as Investments

so this is a a simple concept it sounds

like to me but I hope you'll spend a lot

of time thinking about its

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consequences now let's talk for a while

about the relationship between risk and

return this is one of the most important

of all the topics when I got to

University of Chicago The Chicago School

of theory with regard to investment had

just been developed mostly between 62

and 64 and I arrived in ' 67 and there

was a graphic that we saw all the time

it shows uh return on the vertical axis

risk on the horizontal axis and an

upward sloping line to the right we call

that a positive correlation one goes up

the other goes up as well now most

people would look at that graphic and

say well that means two things that uh

riskier assets have higher returns and

if you want to make more money the way

to do it is to take more risk I think

that's a terrible formulation very

simply if it were true that riskier

assets produce higher returns then they

wouldn't be riskier would they so that

can't be the right

explanation what the upward sloping line

the positive correlation means is that

Investments that are perceived as being

risky have to be perceived as offering

higher returns to induce people to make

those Investments that makes perfect

sense the only thing is they don't have

to deliver and it's from the possibility

that the projected returns will not be

delivered that the risk ensues when you

look at the old graph the linearity of

the relationship between risk and return

implies a Dependable relationship and

I've always felt that that was

misleading I was never happy uh when I

got out into the real world and and and

had to live with the consequences and so

I developed my own version of that chart

I took some little bell-shaped

probability distributions and I turned

them on their side and I superimpose

them on the same line it's the same

underlying line just now with some

embellishment with the old graph as you

moved from left to right the risk

increased and the return increased but

with this new graft As you move from

left to right the expected return

increases just as it did in the old one

but at the same time the range of

possibilities becomes wider and the

worst outcomes become worse that's risk

this is the way to think about the risk

return

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relationship so now let's talk a little

more about how risk should be handled

what determines investment success and

the best way I have uh to communicate

this to you in my opinion is like the

act of pulling one Lottery Ticket the

outcome from a bowl full of lottery

tickets the full range of possible

outcomes as Dimson said we're going to

have one outcome there could be many

outcomes and the outcome that occurs

never amounts in my opinion

to anything but one ticket pulled from

among the many in my opinion Superior

investors have a better sense for the

tickets in the bowl for What proportion

of them are winners and What proportion

of them are losers than do most other

people that's what makes them Superior

and thus they have a better grasp of

whether it's worth participating in a

any given Lottery and how heavily to bet

now how should each of us deal with risk

I think that risk is best assessed

through subjective judgment since risk

cannot be measured gauging it has to be

the province of subject matter experts

and I'm clearly uh jist on the subject

of

quantification I believe imprecise

qualitative expert opinion about the

probability of

loss is far more useful than precise but

largely irrelevant numbers concerning

past and projected volatility so what is

the essence of risk management Peter

Bernstein again my my hero he said

because of the existence of risk things

are going to be different from what we

expect from time to time how well are we

prepared to deal when it's different

this is a great formulation there's no

challenge dealing with the events when

they turn out as we expected the

question is are we prepared for when

they don't turn out as expected

according to Bernstein risk just means

things are uncertain good things can

happen as well as bad things but I think

the definition of risk should emphasize

the bad things and thus I would say risk

is the possibility that from the range

of Uncertain outcomes an unfavorable one

will be the one that materialize izes it

can consist of suffering a permanent

loss of capital when bad things happen

it can also consist of missing out on

gains when good things happen these

things have to be balanced let's say you

think that if you buy something today

there's a one-third chance it'll be down

in six or 12 months what will you do

about that risk many people will say

well I just wouldn't buy it but what do

you do about the other 2third the chance

that it'll be up in 6 to 12 months how

do you balance the two risks and you

know in the real world we can't make

decisions in one dimension we basically

have to balance I think that risk is

something that should be dealt with uh

constantly continuously not

sporadically that's why I Bridal when I

hear this formulation is this a risk on

Market or a risk off Market remember

risk produces loss when bad things

happen and that's when we need risk

control but I believe we never know when

bad things will happen and thus when

risk control will be needed I think the

right model for thinking about whether

we need risk control isn't American

football is soccer in American football

the team with the ball has the offense

on the field they have four tries to go

10 yards if they go 10 yards they get

four more tries to go 10 more yards and

if they can keep doing it they

eventually score but if the team doesn't

go 10 yards in four tries the referee

Blows the Whistle the ball goes over to

to the other team and they try to go 10

yards in four tries in the opposite

direction so we have two teams switching

between offense and defense changing

Personnel when there are stoppages that

has nothing to do with the real world

the right model as I say is what the

rest of the world calls football the

same 11 people mostly play the whole

game nobody tells you when to be on

offense or defense and there are very

few stoppages in which to adjust tactics

and and

Personnel that's the real world in

investing one of the key decisions is

when to be on offense when to be on

defense how much to allocate to each of

those but nobody tells you when to do it

and nobody stops the game to give you

time I think the best model for

investing and risk management is

automobile insurance we all drive we all

have cars we all have insurance on our

cars but I don't think of us get to the

end of a year and say I wish I hadn't

had Insurance because I didn't have an

accident we like having insurance for

the safety it give us regardless of

whether or not we have an accident in a

particular year I think about the

intelligent bearing of risk for profit

back in 1981 I was interviewed by one of

the first cable networks and uh the

reporter said to me how can you invest

in high yield bonds when you know some

of them are going to go bankrupt and for

some reason I was able to come up with

the right answer on the spot I said the

most conservative companies in America

are the life insurance companies how can

they Ure people's lives when they know

they're all going to die and I think

it's an interesting question but the

life insurance company is number one

taking a risk that it's aware of they're

not shocked when somebody dies that's

the way it goes number two they take a

risk they can analyze and when I was a

young man and got my first insurance

policy they sent a doctor to my house to

see if I was healthy number three they

take a risk that can be Diversified so

no life insurance companies insure just

smokers or just people who live in on

the San Andreas fault or just

skydivers just young people or just old

people they have a mix a diversified

portfolio and they take a risk that

they're well paid to Bear they figure

out the probability of what they're

going to have to pay you based on

Actuarial assumptions they allow some

windage for the uncertainty and then

they charge you a premium we do the same

we take credit risk that we're aware of

we analyze it we take a risk that we can

diversify we have large numbers of

Holdings in every portfolio which

respond to different factors and it's a

risk we're well paid to Bear we get

What's called the risk premium or a

yield premium to take the risk of

default so the bottom line is that I

believe risk is kept under control in

Superior portfolios that's one of the

things that Superior investors do highly

skilled investors assemble portfolio

that will produce good returns if things

go as expected and resist declines if

they don't this asymmetry is in my

opinion the critical element the

Cornerstone of superior investing

assembling a portfolio that incorporates

risk control along with the potential

for gains is a great accomplishment but

it's often a hidden accomplishment

because risk only turns into loss

occasionally When the tide go goes out

but The Prudent investor and hopefully

his or her clients knows that risk is

being controlled even at times when it

doesn't come to the surface so I think

that risk is something to be managed and

controlled but not avoided risk control

is indispensable risk avoidance is not

an appropriate goal in investing Will

Rogers said you've got to go out on a

limb sometimes because that's where the

fruit is I think and my experience tells

me from watching others that risk

avoidance equates to return

avoidance intelligent bearing of risk

should be able to enable us to make good

returns with the risk under

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control so what's the bottom line of all

that

foregoing 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 on the basis

of accurate subjective judgments made by

experienced expert investors who

emphasize risk

Consciousness the great challenge in

investing is to limit uncertainty and

still maintain substantial potential for

gains and in conclusion I'll just say

that outstanding investors are out

standing for the simple reason that they

have a

superior sense for the probability

distribution that governs future events

the tickets in the bowl and for whether

the potential return compensates for the

risks that lurk in the distribution's

unattractive left-and tail this is what

enables them to achieve the asymmetry

that characterizes Superior investors

participating strongly in the game GS

when there are gains and avoiding many

of the losses when there are losses I

hope the foregoing discussion will help

you be among

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them for