Dear Readers,
If you have not read Howard Marks’ most recent memo, you should read it! Why? In a market where it is easy to be swept away in the general euphoria of a bubble, Marks is one of those voices that help me stay grounded in my thoughts and remain rational. This is very important to me as an investor because it is incredibly easy to make a bad decision in a second, and extremely difficult to undo that bad decision with a good choice without spending a lot of years.
I really enjoyed this memo, mostly because it discusses what I consider to be a vastly under-discussed topic in the investing community: risk. I wanted to distill some of the key takeaways from this memo in this post.
Managing risk
Every investment has an element of risk. This might sound obvious as you read it. But as an investor, until you have lived through one of your supposed “safe investments” going south, this statement will not resonate as well with you. I have a perfect example of one such investment in my own portfolio that I had to sell out of recently : 3M (ticker: MMM). At the time of starting a position in 3M, I would never have imagined the two lawsuits that 3M got involved in. And we still do not know how this story will eventually play out. But what we do know is that even a dividend darling like 3M, a company that has been around forever, whose products are so deeply embedded in our livelihoods, is NOT a “safe investment”.
So a natural outcome of this observation then is that we all are undertaking some amount of risk with each investment choice. The only way to truly expect to get good returns from each of these investments is by analyzing risk such that (a) it does not exceed beyond a specific desired threshold, and (b) the generated returns sufficiently compensate us for taking on that risk.
The part where this discussion gets tricky is how does one sufficiently quantify risk. Is it based on the stock’s recent volatility? Is it based on the nature of the business i.e. the sector it is involved in? Is its performance based on perceived political and/or economic outcomes heading into the future? Does this also need to factor in the quality of the management running those businesses? There are so many parameters and it is almost impossible to attribute a number to any/most of these. It is for the same reason that I find it hard to believe dividend safety scores reported by services like Simply Safe Dividends. What does a dividend safety score of ’70” (supposedly a “Safe” score) mean when considered in a vacuum? After all, all dividends appear safe/moderately safe/borderline safe until they are eventually cut.
Lets step back a bit. Perhaps, we do not need to quantify risk in the first place. But rather accept it as a reality and plan around it. Luckily, there are several strategies available to us investors to do so. In order to avoid single stock risk, pundits suggest that you diversify your investments across several stocks belonging to different sectors. This lessens the blow to your overall portfolio in case one of your bets does not work out as planned i.e. the risk associated with that stock becomes a reality. The other strategy is to bake in a sufficient margin of safety into your valuation. The greater the unknowns with an investment, the higher the margin of safety. So in the event that the stock performs terribly leading to a complete loss of capital, at-least your cost basis was low enough to ensure that the loss is minimal. I have discussed both of these strategies on previous blog posts.
How to view risk
So we have ascertained that risk avoidance is a futile exercise and we should instead focus on controlling risk within our portfolio. But control it by how much? Of course, we do not want to go overboard in this pursuit because very low risk would correspondingly mean very-low returns. This is where the discussion in the memo becomes very interesting. Traditionally, the risk vs return graph looks like the one shown above: a linear relationship. Marks argues that this picture is misleading, because if this where truly the case, riskier investments would not really be that risky. Marks instead proposes the graph below.
So the relationship looks like a linear graph but composed of a super-imposition of several normal distributions. The point here being that as we choose more riskier investments, the range of likely outcomes becomes that much more wider.
I love this second graph! It is indeed far more accurate that the earlier graph. Less risky investments have a far narrower probabilistic distribution of expected outcomes, making them that much more “safer”. This is precisely why investing in businesses in an early stage of their life-cycle or what are popularly touted as “growth stocks” is far more riskier than investing in blue-chip stocks. It is not that one is a bad investment as compared to the other. Instead, the range of possible outcomes with a growth stock is far wider, as compared to that of a blue chip stock.
So a balanced portfolio is one which can find a ideal “sweet spot” in the middle: one where risk is under control and one where return is also not very low. This is obviously a very difficult exercise, but it once again makes the case for why diversification is important. There is no doubt that you can obtain extraordinary returns by investing in a few winners, but you expose your portfolio to a wider range of outcomes in that pursuit, a lot of which are simply unpredictable and not in your control.
Comparison to Professional Tennis Strategies
The part of the memo that I found fascinating was the comparison of investing strategies to that of what professional tennis players used in recent Grand Slams. In the memo, Marks comments on the Wimbledon games between Carlos Alcaraz vs Novak Djokovic and Christopher Eubanks vs Daniil Medvedev. For the benefit of my readers who do not follow professional tennis:
- Novak Djokovic: Arguably one of the greatest tennis players of all time, in the same league as two other legendary tennis players: Rafael Nadal and Roger Federer. The three players are referred to as the “Big 3”.
- Daniil Medvedev: A professional tennis player who has been playing for several years now and come close to winning tournaments outside of the “Big 3”
- Carlos Alcaraz: A young upcoming professional tennis player who climbling up the ranks very quickly with his aggressive play and is stepping into the mantle of the “Big 3”.
- Christopher Eubanks: Another young upcoming tennis player who is far lower ranked that the rest of the above, but surprised everyone with his aggressive play in the Wimbledon tournament earlier this year.
So in investing terms, Novak Djokovic like a classic blue chip stock, incredibly hard to bet against, been around for a long long time, successful etc. Daniil Medvedev is probably one rung lower, but equally reliable. Carlos Alcaraz is next, with a higher-risk game but very effective when it comes good. Eubanks is in the similar mould, but far more riskier and more unproven.
The point of this comparison exercise being: Alcaraz, in order to have the best chance of winning against someone like Djokovic, needs to be more aggressive: going for frequent winners, and taking the risk of more unforced errors. If it comes off, like it did in the Wimbledon final this year, Alcaraz will win hands down. But there is a good possibility of it NOT coming off because of the nature of the strategy itself. This is similar to growth stocks versus classic blue chip companies. Growth companies need to be very aggressive in their strategies to acquire market share from the far more seasoned blue chip companies. But in that pursuit, they run the risk of things not working out and failing as a business.
One aspect which don’t think Howard Marks touched on is that players like Djokovic, due to their vast experience, are very smart at picking those moments when taking a risk would bear the maximum reward. They, therefore, can choose to step off the gas a little bit, choosing to conserve energy and make better use of their opportunities to win. This is a key attribute of classic blue companies with smart management teams that have been around the industry long enough to know which moments to seize on and which moments to step back.
Summary
Your risk appetite can define your investment strategy. There is nothing wrong with going for more winners, or focusing on minimizing losers. There is no right or wrong answer. There is no black or white. But rather multiple shades of grey.
In my case, I prefer a balanced strategy where I have enough exposure to winners and also enough exposure to defensive plays as well. And I think this balanced strategy works well for me in my current state. This might end up changing as I progress towards my retirement and begin to reduce my exposure to aggressive bets.
Of course, your strategy and thought process around this subject could be completely different. That is what makes investing so exciting and wonderful.
Until next time..
LWD
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