Lesson 7 of 7
Marks on risk and cycles
Howard Marks defines risk as the chance of permanent loss, not volatility, and asks where the cycle stands before asking what happens next. Here is the method.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Marks defines risk as the chance of a permanent loss of capital, not how much a price moves day to day.
- Second-level thinking asks what everyone already believes, and what that leaves out of the price.
- Instead of forecasting what happens next, Marks asks where the cycle stands: cheap credit or tight, greed or fear.
One of Howard Marks's central points is that risk is not the same thing as volatility. A quiet share price can still lose your capital for good; a choppy one can still return it in full.
Volatility and permanent loss are not the same axis
RowsWhat happens to the capitalColumnsPrice behaviour
Recovers, Rough
Rough, and recovers
Recovers, Calm
Calm, and recovers
Permanent loss, Rough
Rough, and lost
Permanent loss, Calm
Calm, but lost
Risk is the chance of permanent loss
Volatility is how much a price swings. Marks's definition of risk is narrower and more specific: the chance that capital is lost and never recovered. A stock that falls hard and recovers has been volatile. A business that goes to zero has delivered the risk Marks means, whether its price got there smoothly or violently.
Second-level thinking
A first-level thought stops at whether the business is good. A second-level thought asks what the price already assumes: if everyone agrees the business is good, that agreement is probably already in the price, and the return left over depends on what the price has not yet accounted for. See Cycles and second-level thinking for the fuller version of this habit.
Where does the cycle stand
Marks does not try to forecast what a market does next. He asks where the cycle stands now: how loose credit is, how eager investors are to take risk, how each answer compares with its own history. The same company can carry very different risk depending on the answer.
Taking a market's temperature
- Are investors, in aggregate, greedy or fearful right now?
- Do current prices assume a rosy future or a harsh one?
- Is risk being sought out eagerly, or avoided?
- Is capital being raised easily, or with difficulty?
A memo written in real time
Marks's January 2000 memo "bubble.com" argued the case while internet stocks were still rising, not after they fell. Applying the method at the time it matters, not in hindsight afterward, is the harder half of the discipline.
Check yourself
In Marks's definition, risk is mainly a measure of what?
- How much a stock's price moves day to day
- The chance of a permanent loss of capital
- A stock's beta against a market index
Show the answer
Answer: B.
Marks separates risk from volatility. A quiet price can still lose money for good; a rough one can still come back.Second-level thinking asks which question?
- What did the stock do yesterday
- What does everyone already believe, and what does that leave out of the price
- What is the highest price this stock has ever reached
Show the answer
Answer: B.
If a view is already the consensus, it is probably already priced in. The useful question is what is not yet accounted for.A share price barely moved for five years, then the company failed. In Marks's terms, was it low-risk?
- Yes, since a low-risk stock is by definition a quiet one
- No, since capital was permanently lost regardless of how calm the price looked
- The question cannot be answered without a beta figure
Show the answer
Answer: B.
Marks's risk is the chance of permanent loss, not how the price behaved along the way. A quiet quote can still lose the money for good.Sources
- Marks, The Most Important Thing, 2011: second-level thinking; risk is not volatility.
- Marks, Mastering the Market Cycle, 2018: cycles, and knowing where we stand.
- Marks, memo "bubble.com," Oaktree Capital, January 2000.
What this leaves out
- The two-stage cyclical example is illustrative, not any named company's filed history.
- Where a cycle currently stands is a judgment call. Nothing here scores market sentiment as a figure.
- Nothing here is advice about any security.