Risk Control

Hi Friend,

Here is a wonderful treatise on ‘Risk Control’ from Mr. Howard Marks.

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• Investors can calculate risk metrics like VaR and Sharpe ratios (we use them at Oaktree; they’re the best tools we have), but they shouldn’t put too much faith in them. 
• The bottom line for me is that risk management should be the responsibility of every participant in the investment process, applying experience, judgment and knowledge of the underlying investments. 
• While risk should be dealt with constantly, investors are often tempted to do so only sporadically. 
• Since risk only turns into loss when bad things happen, this can cause investors to apply risk control only when the future seems ominous. 
• At other times they may opt to pile on risk in the expectation that good things lie ahead. 
• But since we can’t predict the future, we never really know when risk control will be needed. 
• Risk control is unnecessary in times when losses don’t occur, but that doesn’t mean it’s wrong to have it. 
• The best analogy is to fire insurance: do you consider it a mistake to have paid the premium in a year in which your house didn’t burn down? 
• Taken together these six observations convince me that Charlie Munger’s trenchant comment on investing in general – “It’s not supposed to be easy. Anyone who finds it easy is stupid.” – is profoundly applicable to risk management. 
• Effective risk management requires deep insight and a deft touch. 
• It has to be based on a superior understanding of the probability distributions that will govern future events. Those who would achieve it have to have a good sense for what the crucial moving parts are, what will influence them, what outcomes are possible, and how likely each one is. 
• Following on with Charlie’s idea, thinking risk control is easy is perhaps the greatest trap in investing, since excessive confidence that they have risk under control can make investors do very risky things. 
• Thus the key prerequisites for risk control also include humility, lack of hubris, and knowing what you don’t know. 
• No one ever got into trouble for confessing a lack of prescience, being highly risk- conscious, and even investing scared. 
• Risk control may restrain results during a rebound from crisis conditions or extreme under-valuations, when those who take the most risk generally make the most money. But it will also extend an investment career and increase the likelihood of long-term success. That’s why Oaktree was built on the belief that risk control is “the most important thing.” 
• Lastly while dealing in generalities, I want to point out that whereas risk control is indispensable, risk avoidance isn’t an appropriate goal. 
• The reason is simple: risk avoidance usually goes hand- in-hand with return avoidance. 
• While you shouldn’t expect to make money just for bearing risk, you also shouldn’t expect to make money without bearing risk. 

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Thank you.

Source: Risk Control by Mr. Howard Marks