Why investors need to reconsider what 'risk' really means

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

Photo: Howard Marks. Credit: Oaktree Capital

Comments

[Turn Back the Clock]

The problem is also that "experienced, insightful" professionals are few and far between. It's become an overall sleazy game with the worst kind of personalities running the show. Even when you give your money to a "professional" they just forward to some third party machine that dumps in some cookie cutter portfolio.

[Nikkei 225]

The tricky thing is the fact that the professionals can't be trusted anymore, if even the big established names invest your money at Bernie's or some other murky hedgefund then your investment is gone as well. You as an investor may be risk averse if your banker isn't your still going down with the flow.

[martscan]

There is no arguing with Howard Marks' success, philosophical bent, and his private equity and hedge fund investment policies that reflect his long standing mantra of risk aversion. But I sense more than a tinge of hubris when he implies that participation (democratization), or decision making, in equity markets should be the exclusive purview of 'subjective, experienced, professionals'. Lacking having discretion in the direction of billions of dollars with which to employ various esoteric investing strategies, including utilizing PhDs and their 'machines', incredibly diverse portfolios and hedging conventions, as he does...it hardly takes much skill for 'Joe 6 pack' to dollar cost buy the S&P Index. And that is sound counsel of highly subjective, experienced professionals.

Regarding the utilization of "machinable processes, quant funds, computer models, algorithms, etc", I daresay Einstein would consider them countable things that do count. In my opinion, fault does not lie with these virtual mechanical contrivances, the fault was the failure of subjective, experienced professionals in not recognizing the advent of a, not uncommon, bear market, and pulling the plug of the machines.

[Leslie]

Until Fall of 2008 Bernard Madoff was considered to be one of the “subjective, experienced, professionals.” Given his former position as a non-executive chairman of the NASDAQ his clients had every reason to believe his investment firm was above board and not a Ponzi scheme. But, just because someone is a professional does not mean that they have the best interests of their clients at heart.