Risk Redefined
I was recently introduced to the memos of Howard Marks, billionaire investor and co-founder of Oaktree Capital Management, which invests in distressed securities. He has been writing regular memos on financial topics since 1990, so it is extremely interesting to read his insights on market conditions prior to and during times of crisis in the financial world, especially considering the current climate we're in. Of course, even he can't predict the future, and his quote "If you've never experienced something before, you can't say you know how it's going to turn out" is especially relevant now, but it's still interesting to get his insight considering the other crises he has seen.
I plan on reading all of them chronologically now that I've read about a dozen of them from various time periods. One topic he refers to often is risk management since he feels it is an undervalued consideration in the financial world. Part of the reason is it's hard to attach a number to it. It's more of a qualitative concept than a quantitative one and seems to be swept under the rug when considering investments.
To understand risk, it's important to first understand the simple chart below. This is known as the "capital market line" and shows the relationship between risk and returns.
Simply put, the more risk you take on the higher the return. But this leaves out an important distinction that Marks points out. Most people look at this and think that you have to simply take on more risk to achieve a higher return. But as Marks says, "riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It's simple: if riskier investments reliably produced higher returns, they wouldn't be riskier!" The distinction is that in order to get people to invest, these investments must offer the PROSPECT of higher returns. But the key is, it's far from a guarantee, and could even be unlikely.
What I find most interesting of all is how various investment classes can be plotted on this capital market line. It all starts with the 30 day US Treasury Bill, which is considered a riskless investment as it is backed by the US Government. So if the 30 day T-bill has a 2% yield, in order to extend the time to maturity out to 5 years, you might want 3% because it would take you longer to get your money back. If you were considering buying the 10 year note, you would want 4% because that's even more time to maturity. Since the US Government has arguably the lowest risk of default in the world, you're not worried about repayment in that sense. So how much of a return would you require to invest in a corporate bond? Obviously more than 4% because the corporate bond has a higher risk (relative to an entire country) of going out of business, so you might say you want at least 5%.
Since stocks aren't considered fixed income, it gets a little more difficult to project a return into the future, so let's keep it broad. Most people are aware that historically stocks have returned 10%. So naturally, the riskier the underlying company, the more return you demand. Because of the illiquidity of real estate, you might want at least 13% to compensate for it. Beyond that, investments like venture capital tend to have the highest prospect for returns of 30% and more, but are much riskier because there is a lower chance of success, much like the companies you see on the show Shark Tank.
(Source: Howard Marks Memo October 27, 2004)
So as you can see, the prospective returns start from the US treasury note and work their way up the capital market line. So what does that imply in a low interest rate environment like we are in today when the yield on the 30 day t-bill is .09%? The short answer is that the capital market line flattens out as you see in the lower line, which means that investors who are seeking a certain return are more and more willing to go further out on the capital market line in order to hit their targets. Not only that, since there is a relationship between risk and return, a low return environment is perceived as being a low-risk environment, so money starts to flow into higher risk classes, which drives the prices up, which lowers the return. Eventually, the deals start to go bust, and those that paid too much are the first to get hit when prices correct, which they always do.
This is how bubbles are created, so in times like this, in a low return environment, it is especially important to be conscious that while returns are down, risk is not. Good deals are getting harder and harder to find as prices get bid up by eager capital in search of yield, so we have to be more disciplined in our approach and underwriting than ever before.
