The Rational Investor #036: Howard Marks on Volatility
Happy Saturday to you,
Welcome to the 36th edition of The Rational Investor Newsletter.
Given that today's media coverage is now entirely focused on the return of market volatility, I thought it might be helpful to share some thoughts on the topic. Today’s quote comes from Howard Marks’s 2015 memo, Risk Revisited Again. I say it every time I share a quote from Marks’s memos, but I believe they are the best single source of investment education available today. [The only other source in the running is Buffett’s shareholder letters.]
As for today’s quote, Marks explains why volatility should not be synonymous with “risk.” The only change I’ve made to the quote is that I’ve broken up the paragraphs for easier reading.
Onto the main event…
Here’s Howard Marks on Volatility [Emphasis is that of the author]:
“In the 2006 memo and in the book, I argued against the purported identity between volatility and risk. Volatility is the academic’s choice for defining and measuring risk.
I think this is the case largely because volatility is quantifiable and thus usable in the calculations and models of modern finance theory. In the book I called it ‘machinable,’ and there is no substitute for the purposes of the calculations.
However, while volatility is quantifiable and machinable — and can be an indicator or sympton of riskiness and even a specific form of risk — I think it falls far short as ‘the’ definition of investment risk.
In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility.
In fact, I’ve never heard anyone say, ‘The prospective return isn’t high enough to warrant bearing all that volatility.’ What they fear is the possibility of permanent loss.
Permanent loss is very different from volatility or fluctuation. A downward fluctuation — which by definition is temporary — doesn’t present a big problem if the investor is able to hold on and come out the other side.
A permanent loss — from which there won’t be a rebound — can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing — whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but we never get a chance to undo a permanent loss.”
Okay, Marks shares some great thoughts here, and I’d like to hone in on two things.
First, let’s start with part (b) in the final paragraph. He’s obviously referencing the ownership of individual securities rather than the ownership of a market-like portfolio because the risk of permanent loss with the ownership of a market-like portfolio is historically zero. This should give us great confidence about the future and offer further support for the ownership of a market-like portfolio.
Secondly, let’s now go to section (a) in reference to a temporary dip or downward fluctuation. Those happen all the time, regardless of which security you own, including a market-like portfolio. Even bond investors have gotten an abject lesson in volatility over the past few years. But as Marks notes, those temporary dips (otherwise known as volatility) cannot hurt us unless we sell, for whatever reason, during the downswing.
Thus, in combining these two points, it’s reasonable to say that the two keys to earning satisfactory long-term returns are to own a market-like portfolio (thereby avoiding the individual security risk of permanent loss) and then, quite simply, never ever selling (thereby avoiding the behavioral risks associated with temporary volatility).
Good planning and a trusted advisor make those tenants much easier to adhere to.
It won’t always be easy, but it surely is simple.
Thanks for reading. I’ll be back again next week with more timeless wisdom from great investors.
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