Risk Versus Volatility

Howard Marks, Chairman of Oaktree Capital Markets released his most recent client letter, Risk Revisted. As Marks notes in his letter, he dedicated three chapters of his book, The Most Important Thing, on the subject of risk. In his client letter, he expands on risk and discusses 24 different forms of risk. A couple of highlights from his client letter:

• There’s little I believe in more than Albert Einstein’s observation: “Not everything that counts can be counted, and not everything that can be counted counts.” I’d rather have an order-of-magnitude approximation of risk from an expert than a precise figure from a highly educated statistician who knows less about the underlying investments. British philosopher and logician Carveth Read put it this way: “It is better to be vaguely right than exactly wrong.”

• No ambiguity is evident when we view the past. Only the things that happened happened. But that definiteness doesn’t mean the process that creates outcomes is clear-cut and dependable. Many things could have happened in each case in the past, and the fact that only one did happen understates the variability that existed. What I mean to say (inspired by Nicolas Nassim Taleb’s Fooled by Randomness) is that the history that took place is only one version of what it could have been. If you accept this, then the relevance of history to the future is much more limited than may appear to be the case.

• Knowing the probabilities doesn’t mean you know what’s going to happen.

• Bruce Newberg says, “There’s a big difference between probability and outcome.” Unlikely things happen–and likely things fail to happen–all the time. Probabilities are likelihoods and very far from certainties.

His letter is a worthwhile reading for investors. The potential risks facing investors searching for yield is elevated in an environment where the Fed has pushed interest rates to near zero. Equally, the search for capital appreciation is equally challenging as equity prices are no longer at levels reached subsequent to the financial crisis.