Howard Marks’ latest memo on risk has sparked interesting conversations on the web. Mr. Marks points out that volatility is very incomplete definition of investment risk:
Risk is something people worry about and therefore demand compensation. What people fear most is the possibility of a permanent loss.
Permanent loss could occur for two reasons:
a) an otherwise temporary blip is locked in when an investor sells during a downswing – whether because of a loss of conviction; requirements steaming from his time frame; financial exigency; emotional pressures or
b) the investment itself is unable to recover for fundamental reasons
We can ride out volatility, but we never get the chance to undo a permanent loss
Howard Marks looks at risk from the position of a long-term investor, not from a trader’s perspective.
A trader is not worried about taking a permanent loss. Permanent loss on some of his trades is part of his process. Sometimes being wrong is not a choice. Staying wrong always is.
A temporary dip could last quite some time and turn into a much bigger dip. A 10% loss takes an 11.11% gain to recover from. A 80% loss takes a 400% gain to recover from. There is an opportunity cost behind every decision you make. A losing asset could manage to fully recover to your initial purchase point, but what is to say that you could not have sold at a small loss and used to proceeds to buy another asset that ends up actually making you money. As a trader, you don’t have to make money in the first one or two stocks or assets you buy. The market is an opportunity machine. It provides a good number of opportunities every single week.
Is uncertainty risk? No, uncertainty is always here. You don’t need to know that something will happen with 100% certainty, in order to take advantage of it. Circumstances will never be ideal, but if you follow a process with an edge you will end up with more than you have began with.
Risk is what’s left after you think about and prepare about anything that could go wrong. If you are prepared for it, is it really a risk or a mere part of the process of trading? Forget about measuring the probability of each scenario that could unfold. If you have an action plan for every possible scenario, then those scenarios are not risk events, but just possibilities. Therefore a good definition of risk is a black swan.
According to Nicholas Taleb, black swans are “large-scale, unpredictable and irregular events of massive consequence”. This definition is a little too grandiose. Black swans could be very subjective. If you don’t know what you are doing or if you are not prepared for a possible event, it could be a black swan for you. It is not a black swan for someone, who is prepared for it. Thanksgiving is a black swan event for the turkey, not for the butcher.
You might know about certain risks, but if you are unprepared for them, they remain risks for you. Sometimes, the cost of insuring against every possible risk is too high and you deliberately decide to take your chances.
Basically, the most practical definition of risk is something you are not prepared for.
