The Rational Investor #024: Howard Marks on the Disconnect Between Risk and Outcomes
Happy Saturday to you,
Welcome to the 24th edition of The Rational Investor Newsletter.
Today’s quote comes from Howard Marks's book The Most Important Thing Illuminated. And as he states in the book, the quote is directly pulled from his 2006 memo titled Risk.
The topic is one that is near and dear to my heart—the disconnect between risk and outcomes. We’ve all seen people who made terrible decisions that turned out wonderfully (e.g., overconcentration in an individual stock, buying fad investments, etc.), and decisions like those are what Marks is getting at here.
Onto the main event…[emphasis is mine]
Here’s Howard Marks on the Disconnect Between Risk and Outcomes:
“In the investing world, one can live for years off one great coup or one extreme but eventually accurate forecast. But what’s proved by one success? When markets are booming, the best results often go to those who take the most risk. Were they smart to anticipate good times and bulk up on beta, or just congenitally aggressive types who were bailed out by events? Most simply put, how often in our business are people right for the wrong reason? These are the people Taleb calls “lucky idiots,” and in the short run it’s certainly hard to tell them from skilled investors.
The point is that even after an investment has been closed out, it’s impossible to tell how much risk it entailed. Certainly the fact that an investment worked doesn’t mean it wasn’t risky, and vice versa. With regard to a successful investment, where do you look to learn whether the favorable outcome was inescapable or just one of a hundred possibilities (many of them unpleasant)? And ditto for a loser: how do we ascertain whether it was a reasonable but illfated venture, or just a wild stab that deserved to be punished?
Did the investor do a good job of assessing the risk entailed? That’s another good question that’s hard to answer. Need a model? Think of the weatherman. He says there’s a 70% chance of rain tomorrow. It rains; was he right or wrong? Or it doesn’t rain; was he right or wrong? It’s impossible to assess the accuracy of probability estimates other than zero and 100 except over a very large number of trials. The celebrated investor is one whose actions yielded good results. Was she lucky or good? How much risk did she take? Since it’s risk-adjusted return that counts, can we tell whether her return was more than commensurate with the risks borne or less than commensurate? I’m confident that the answers lie in skilled, subjective judgments, not highly precise but largely irrelevant ratios of return to volatility.”
You see, the connection between risk and outcomes is often cloudy, at best.
I heard Carl Richards once discuss this idea at the extreme. It was a story about a guy who put his entire life savings on one spin of the roulette wheel and won. Nobody is going to say that was smart, but it worked out.
The unfortunate truth is that when poor decisions turn out beautifully, it can cause people (not us, of course) to mistake luck for skill.
And as you well know, once people start confusing luck for skill, their financial future is almost certain to end in ruin. It’s only then that they’ll acknowledge that they experienced a run of bad luck since the ill-fated outcome could never have been the result of poor skill. We humans will do literally anything to preserve our self-image.
Thanks for reading. I’ll be back again next week with more timeless wisdom from great investors.
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