When the stock market’s gone up for several years it’s easy to get complacent and ignore the changing risk in your portfolio. Why sell or rebalance or adjust an allocation when equities are doing so well? Because investing has tradeoffs in risk and return. When you only have a plan for moves higher, you leave yourself unprotected from worse markets.
Risky events don’t happen on a timely basis. There are no giant neon signs that flash, “It’s time to get out!”
Instead, we hear pundits droning on about the “risks” from trough to peak. In other words, quantifying risk is hard:
I personally think that quantifying risk is an oxymoron. I think that risk cannot be measured in numbers. Seth can tell you, he can look at something and give me the probability of losing 20%, and David can give me the probability of losing 50%, and somebody else can tell me the chances of having a loss, and they’ll all be different, and nobody will look at it the same way, and the numbers won’t be comparable because David’s inherently more optimistic than Seth is. And I think that the business about volatility being risk is a con job which was perpetrated primarily becasue volatility is machinable. It’s measurable prospectively. You can apply it to the future. You can compare the volatility of one asset class with another. But I think that the job of measuring risk requires the same thing as the job of measuring prospective return which is a superior skill on the part of the individual.
And to add one last thing. And if you want to think about trying to measure the risk of an investment you’re thinking about taking, think about some of the investments you’ve made in the past and completed, and think about whether or not they were risky. I mean, the fact that something worked doesn’t mean it wasn’t risky. The fact that something didn’t work doesn’t mean it was risky. And if you recognize that you can’t meansure it in retrospect then clearly you can’t measure and quantify it in prospect. – Howard Marks
That doesn’t really help much. So what is an investor to do?
With time and experience, you can get a general sense of the change in risk through changes in investor behavior throughout a market cycle.
But I think the soul of value investing, one of things at the root, is kind of an attitude of it is what it is. And our number one job is to figure out what’s going on in the market today and what’s the appropriate response. And what’s going on today of course is the total lack of confidence, probably overdone, in the financials. And thus securities,…at once in a lifetime prices, which tend to happen every few years.
What I realize is that I didn’t predict one thing that’s happened this year. What I did predict is something bad would happen and when I say it is what it is I believe that it’s our job to look in the environment and say what’s going on? How are our investors behaving? What actions have they taken? What structures can now be done, that shouldn’t be done? And that kind of thing and respond. You know, if you went back a year and a half ago, what you see in the paper is a global wall of liquidity. That’s all we heard about. There’s this money coming, and it’s coming, and it can’t stop, and it’s infinite, and it will always take every asset higher and higher. And when you hear that stuff you know there’s something wrong and you don’t know how it’s going to end but you know it can’t go on and — Who was it, Herb Stein, who said anything that can’t continue will end? And when behavior is ridiculous and risk is ignored it will stop, and the end will be ugly. And the more ridiculous the excesses on the upside the uglier the unwind. – Howard Marks (in Oct. ’08 following the financial crisis)
It’s not an exact science, but it’s a start.
Several decades ago Ben Graham offered a simple common sense solution to this problem. He suggested that you always own some stocks and bonds. He suggested holding a 25% minimum no matter what, then make occasional adjustments to control for changes in risk. Doing so means you never miss out as the market moves higher, you’re protected when the market falls, and you always catch the turn at the bottom.
Graham’s minimum holding also means survival:
…I wrote out a list of what I thought were the lessons of ’07 and I thought that the most important one, the best one, was that investment survival has to be achieved in the short run, not on average in the long run… But the upshot of that is that investors have to make it through the low points and because ensuring the ability to do so under adverse circumstances is incompatible with maximizing returns in good times, investors must choose between the two. And that’s really the key to survival. And you know, incredible as it sounds, and we tend to lose track of this, survival is an essential component of success. – Howard Marks
Graham and Dodd Luncheon Symposium 2008
Howard Marks on Risk, Predictions, and History
Ben Graham on Market Cycles and Second-Level Thinking