Billionaire debt investor Howard Marks has warned investors about the risk of not taking on any risk in their investment portfolios.
In a new memo, the co-chairman of Oaktree Capital Management compared risk taking in finance with the game of chess, where players may have to make sacrifices in order to secure a win.
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“The risk inherent in not taking enough risk is very real,” wrote Marks.
“Individual investors who eschew risk may end up with a return that is insufficient to support their cost of living. And professional investors who take too little risk may fail to keep up with their clients’ expectations or their benchmarks.
“The paradox of risk-taking is inescapable,” he added. “You have to take it to be successful in competitive, high-aspiration arenas. But taking it doesn’t mean you’ll be successful; that’s why they call it risk.”
Marks noted that every type of investment requires the investor to make some sort of sacrifice. The greater the risk, the more ‘real’ the sacrifice may be.
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“Because the future is inherently uncertain, we usually have to choose between ‘a’ avoiding risk and having little or no return, ‘b’ taking a modest risk and settling for a commensurately modest return, or ‘c’ taking on a high degree of uncertainty in pursuit of substantial gain but accepting the possibility of substantial permanent loss,” Marks wrote.
“Everyone would love a shot at earning big gains with little risk, but the ‘efficiency’ of the market – meaning the fact that the other participants in the market aren’t dummies – usually precludes this possibility.
“Most investors are capable of accomplishing ‘a’ and most of ‘b.’ The challenge in investing lies in the pursuit of some version of ‘c.’ Earning high returns – in absolute terms or relative to other investors in a market – requires that you bear meaningful risk – either the possibility of loss in the pursuit of absolute gain or the possibility of underperformance in the pursuit of outperformance.
“In each case, the two are inseparable.”
Marks recommended diversification as a tool that investors can use to reduce the risk of their portfolios.
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“You have to take a shot,” he wrote.
“Not every effort will be rewarded with high returns, but hopefully enough will do so to produce success over the long term. That success will ultimately be a function of the ratio of winners to losers, and of the magnitude of the losses relative to the gains. But refusal to take risk in this process is unlikely to get you where you want to go.
“The bottom line on the quest for superior investment returns is clear: You shouldn’t expect to make money without bearing risk, but you shouldn’t expect to make money just for taking risk.
“You have to sacrifice certainty, but it has to be done skilfully and intelligently, and with emotion under control.”
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