Howard Marks released his latest memo: risk is indispensable

Edit | Li Jian

Howard Marks, a prominent investor, set out the role of risk in investing in a "memo" released on April 17.

The memo, titled "The Necessity of Risk," describes the relationship between sacrifice and investment risk in chess. As Maurice Ashley describes in his article "Chess Teaches the Power of Sacrifice", "Sacrifice" is defined as "the deliberate loss of a piece in a game plan".

Howard likens investing to such a game, "Buying a 10-year Treasury bond is a modest or 'scam' sacrifice." You give up 10 years of access to the funds, but it's only an opportunity cost, and it also brings a certain interest income. However, most other investments have made some real sacrifices, taking risks in pursuit of 'returns that are neither direct nor definitive'. ”

He then discussed how investors should view risky behavior, saying that investors "have to accept the fact that success comes from a lot of investment, all the targets that you invest in, and you expect them to succeed, but you know, some of them won't succeed." ”

In the end, Howard concludes that you don't want to make money without taking risks.

Here's a compilation of the meme's highlights:

"Risk is indispensable"

Many times, through analogy, we can gain a deeper understanding of something and clarify the problem by making connections. Every year for the past 40 years, I've written a memo comparing investment to sports operations. I remember in 2020 when I associated investing with bridge.

The inspiration for today's memo came from an April 12 Wall Street Journal article titled "Chess Teaches the Power of Sacrifice" by Maurice Ashley, a chess grandmaster who has been inducted into the U.S. Chess Hall of Fame.

It was my partner Bruce Karsh who forwarded this article to me at the time, and I almost forgot that he was also a chess player, but it inspired me and prompted me to write this memo.

As you can see from the title of this article, I wrote this article mainly to discuss "The Role of Sacrifice". "From humble pawns to powerful queens, you can't win or save a lot of advantageous positions without giving up something valuable," Ashley said. "Ashley's sacrifice refers to deliberately throwing away a piece in the game plan.

• He described some of the sacrifices as "shams" (a term coined by chess grandmaster Rudolf Spearman in his book The Art of Chess Sacrifice). “...... It is not difficult to see that the piece that is given up will bring benefits, and it can be clearly calculated. ”
• There are also those that are considered "real" sacrifices, i.e. "...... The benefits of giving up a piece are neither direct nor clear-cut. The result is to create a vulnerable point in the opponent's position, or to have more pieces in key attack areas. ”

In this way, the contrast with investment becomes clear. Buying a 10-year Treasury note is a modest sacrifice or a "shams" sacrifice. You give up 10 years of access to the funds, get an opportunity cost, and accept the certainty of interest income that comes with it.

However, most other investments involve real sacrifices, the risk of loss in pursuit of "returns that are neither direct nor clear".

Ashe uses risk and reward to explain sacrifice, two words that are all too familiar to investors. He said that in order to have a better life for himself and his two siblings, his mother decided to go to the United States alone to find a possible opportunity for a better life. Ten years later, she achieved her goal of coming to the United States with her children and was successful in many ways:

Things weren't going to work out, and the reason why my mother got what she wanted in the end was because of the key factor in her willingness to take the "real" sacrifice: taking risks.

For chess players, risk is both intuition and calculation. Due to the complexity of the game, it is almost impossible to determine whether a risky move will ultimately pay off. It depends on the player's judgment whether the sacrifice conditions are sufficient to make the next risky move.

We know, however, that the famous saying "no risk, no reward" is true in many cases. Opponents who are skilled at chess are usually able to deal with a steady, conservative game, and are therefore able to take away the opportunity that should be ours. As Magnus Carlsen, five-time world chess champion, said: "Reluctance to take risks is an extremely dangerous strategy".

That's what it is: the indispensability of risk.

Risks that do not take risks

Because the future is uncertain, we often have to choose between (a) risk-averse but little or no gains, (b) moderate risk but only a proportionate return, or (c) a high degree of uncertainty in pursuit of substantial gains but the possibility of permanent significant losses.

Everyone wants huge gains with little to no risk, but the "efficiency" of the market – that is, the fact that no other participant in the market is a fool – makes this almost impossible.

Most investors have the ability to achieve "A" and most of "B", and the challenge is to pursue a certain version of "C". Earning high returns – whether absolute or relative – requires taking meaningful risk – either in the pursuit of absolute returns in the form of potential losses or in the pursuit of alpha in the pursuit of alpha. In each case, risk and reward are inextricably linked. As Ashley said, there is no reward without risk. Without pain, there is no gain.

Not taking enough risks is just as big a risk. The returns for risk-averse individual investors may not be enough to support their cost of living. Professional investors, on the other hand, may not be able to meet their clients' expectations or performance benchmarks if they take too little risk.

Like chess and most card games, backgammon requires the calculation of when to take risks and when to avoid them. In backgammon, two players move pieces on the board based on a pair of dice rolled. One side moves clockwise, and the other moves counterclockwise. When a player's pieces are in close proximity to each other, the moving side usually has a choice: (a) land on the opponent's piece, sending it back to the starting point (but potentially putting the moving piece in a vulnerable position) ;(b) avoid doing so to keep itself safe.

No one wants to be exposed and attacked, but most beginners are overly cautious and they put too much emphasis on avoiding getting hit, so they rarely win.

Relevant experience in sports is easy to gain and very helpful for us:

"You're 100% going to miss an opportunity you didn't take". —Wayne Gretzky, NHL Hall of Famer

"You have to give yourself a chance to fail". - Two-time NBA champion Kenny Smith "Jets".

In my September memo, "Fewer Losers, or More Winners?," I summarized the connection between sacrifice and risk:

...... Avoiding failure is not a useful goal, and the only way to achieve it is without taking risks. But risk aversion is likely to lead to reward aversion, and there is a risk called "too little risk", which most people understand intellectually, but human nature makes it difficult for many people to consider "taking losses" as an essential ingredient for success.

How to look at adventure

The paradox of adventure is inescapable. You have to take risks in order to succeed in the fierce competition. But taking a risk doesn't mean you're going to succeed, which is why people call it "risk."

Paradoxically, high returns over a longer period of time do not necessarily mean sustained success. More than not, some of these investments have yielded good returns due to the large number of reasonable investments that have been made. Here's how I describe Berkshire Hathaway's success in Fewer Losers, or More Winners?

I think the reasons for Buffett and Munger's success are simple: (a) they have made good returns on many investments, (b) they have a large number of super bull stocks and hold them for a long time, and (c) there are fewer companies that have lost money significantly. No one should expect themselves or their fund manager to buy companies that are rising and not falling.

Investors must recognize that success is likely to come from a large number of investments, all of which are made because you expect them to succeed, but you know that some of them will not succeed. You have to take it all and give it a go.

You want to work hard to achieve higher returns and long-term success, which ultimately depends on the ratio of companies that look right and companies who look wrong. It is impossible to achieve the goal by refusing to take risks in the process.

Finally, I would like to conclude with a quote from Ashley:

Taking risks doesn't directly lead to success, and it doesn't mean that success necessarily requires risk. If there is a good reason, the choice to take the risk should be as firm as a reflex. The more we trust our judgment, the more confident we are in our decision-making abilities. The courage to take risks is a goal worth pursuing in itself.

The bottom line for pursuing excess returns on investment is clear: you can't expect to make money without taking risks, but you can't expect to make money just by taking risks. You have to sacrifice certainty, but you have to do it skillfully, intelligently, and with good emotional control.

April 17, 2024

(The article only represents the author's personal views and does not represent the position of this journal.) ）