Warren Buffett once said: “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something.” Earlier this week, Marks held an AMA (ask me anything) for investors. Here are some of the key takeaways of this dialogue with one of the industry's legends.  

On how he defines risk:

"Risk, not return, is what distinguishes the superior investor: whatever the return may be, I’m convinced the superior investor achieves it with less risk than others.”

“Most people think about investing primarily in terms of the return they might make, but clearly there are not one but two important elements: return and risk.”

“It’s easy to make money in the market, especially in the good years, and most of the years are good. If you look at historical returns, they’re good most of the time, and good on average over the long term.”

“After roughly 50 years in the business, I’m convinced that risk is the more important, intriguing and difficult part of investing. Risk, not return, is what distinguishes the superior investor: whatever the return may be, I’m convinced the superior investor achieves it with less risk than others.”

“But whereas return is easily measured and stated, risk is not.”

“In an attempt to quantify risk, finance academics and theoreticians in the early 1960s chose volatility as the measure of risk. Volatility – or how much an asset price or a stream of returns has fluctuated over time – is easy to quantify. For me, that’s volatility’s greatest advantage. The problem is that, in my opinion, and in the eyes of most investors, volatility is not the real risk (although it might be viewed as a symptom or product of risk).”

“I’ve never heard anyone say, “I’m not going to make that investment: it might be volatile.” What they say is, “I’m not going to make that investment: I might lose money.” Thus I reject defining risk as volatility. For me, risk is mainly the probability of losing money”.

“I’ve never heard anyone say, “I’m not going to make that investment: it might be volatile.” What they say is, “I’m not going to make that investment: I might lose money.”

On how he measures it:

“The future isn’t known or knowable. In fact, I don’t think the future has been determined yet, so how can it be known today? It can only be guessed at, but investors can try to add value by enumerating the possible outcomes and estimating their probabilities.”

Essentially:

• Many outcomes are possible.
• We can’t know which of them will happen.
• At best we can list them and assign them probabilities.
• Even if we do so correctly, the actual outcome will still be in doubt.
• Invariably there is the risk that some of the outcomes that materialize will be unpleasant.
• The uncertainty surrounding which outcome will materialize, and the possibility that it will be a bad one, are the source of risk.

On understanding how the market cycle can lead to outperformance
 

"The market’s position in the cycle won’t tell you what’s going to happen next, but it will tell you when the odds are in your favour and when they’re against you."

 

“The position of the market in its cycle says a lot about what lies ahead. When the market is low in its cycle, expected future returns are higher than usual and risks are lower. And when it’s high in its cycle, the reverse is true: expected returns are below average and risks are high. The market’s position in the cycle won’t tell you what’s going to happen next, but it will tell you when the odds are in your favour and when they’re against you.”

So, what does a market high in the cycle look like?

“In general, the temperature of the market is raised when the economy is doing well, companies are reporting good earnings growth, and media are issuing positive reports. When this is the case, it’s more likely that investors will be optimistic, investors’ attitudes toward risk will be relatively carefree, and positives in the environment will be emphasized and negatives overlooked. When the news is good and attitudes are upbeat, stocks will be bid up such that valuations are likely to be high (all else being equal) and the market is likely to be rising. When this has gone on for a while, the market eventually will reach a point where it’s high in its cycle.”

“A market that’s high in its cycle means asset prices have been heading higher and shareholders have been enjoying gains, adding to their good mood. That’s good. But it also means stocks have become more expensive (investors – in such a good mood – often overlook this). If stocks are more expensive, that means their expected future returns will be lower than they usually are, and the risks will be higher.”

And a market low in the cycle?

“On the contrary, when the economy is doing poorly, companies are reporting weak earnings and media reports are predominantly negative, investors will be pessimistic and perhaps fearful, investors attitudes toward risk will be defensive, and now it’s the negatives in the environment that are emphasized. When the news is bad and attitudes are downcast, the market is likely to be falling, leading to low valuations. Eventually, the market will reach a point where it’s low in its cycle”.

“A market that’s low in its cycle means asset prices have been falling and shareholders have been experiencing declines. While that’s unpleasant, it means stocks are now cheaper. And if stocks are cheaper, their expected future returns will be elevated and the risks will be lower.”

So how do you invest when the markets are low in the cycle?  

“Invest more aggressively”

 

“To invest aggressively, you want to have more capital invested and generally hold assets that are more gain-oriented. The most important step is to put cash to work, and this is the main thing investors identify with aggressiveness. But there are many elements that fall under that heading. These include emphasizing the following (all else equal):

• More stocks than bonds
• Riskier, lower-quality companies
• Smaller companies
• Growth stocks rather than value
• Cyclical stocks rather than defensive stocks in stable industries
• Non-US investments rather than the safer US
• Emerging market securities rather than the developed world
• Margin in your brokerage account
• Levered investment products
• Aggressive derivatives”

And how do you invest when the markets are high in the cycle?

“It’s desirable to have less in the market, and that the assets you do hold should be more oriented toward protection:

• “More bonds than stocks
• Higher quality companies
• Larger companies (more secure)
• Value stocks rather than growth
• Defensive stocks rather than cyclical stocks
• US investments rather than non-US
• Developed world securities rather than emerging markets
• No margin in your brokerage account
• No use of levered investment products
• Derivatives that hedge

All things being equal – there it is again – these group of tactics should produce bigger gains depending on whether the market is falling or rising. Thus you can intelligently switch between them depending on where the market is in its cycle.

That leaves one last question: if you think the market is high in its cycle and thus positioned for lower returns or losses, why use defensive tactics? Why not just exit the market? The answer is simple: you may be wrong. And even if you correctly exit because of where we are in the cycle, having sidestepped losses, many people forget to go back into the market, and thus they miss out on the future gains. The market’s position in the cycle has to appear particularly precarious – and you have to be right soon – to make leaving the market the right thing to do.”

On emotions in investing

“Emotion conspires with events to make investors do the wrong thing at every turn.”

 

“The goal with regard to cycle positioning is simple: buy low and sell high. But emotion combines with events to make people buy high and sell low, as described above. Do you doubt that? If so, ask yourself what force propels a rising market to the top, and what pushes a defining market to the bottom. Certainly, the answer is buying on the rise and selling on the way down.”

“Clearly, you cannot be a superior investor unless you avoid or control the emotional influences that cause more investors to make mistakes.”

“Eventually, developments will become less positive, or at minimum, they’ll fail to live up to the expectations held by investors who are increasingly optimistic. When developments turn down, emotion will as well. The combination of these two things will cause security prices to fall. And falling security prices will turn back to further sap emotion, leading to further declines.”

Eventually, the sum of these things will cause security prices to go so low that they represent great value. At that point, prospective returns will be above average and risk will be low. But the negative events and emotion will keep most people from buying. This is the time for aggressiveness.”

If you wish to view the full forum, it can be found here.

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Thanks to Eric Nguyen with his assistance in the preparation of this wire.