The Indispensability of Risk: Lessons from Howard Marks

Risk is often viewed as a villain in the investment world, something to be avoided at all costs. However, in his memo "The Indispensability of Risk," Howard Marks, co-founder of Oaktree Capital, presents an essential perspective: risk is not just unavoidable but indispensable to achieving success in financial markets. In this article, we’ll explore Marks' key ideas about the fundamental role of risk in the investment process and how investors can use it intelligently to achieve superior returns.

What is Risk?

First, it’s important to understand how Marks defines risk. He points out that people often confuse risk with volatility or loss. However, risk, according to Marks, is more complex, referring to the possibility that actual investment outcomes may differ from expected ones. Risk isn’t something to avoid but a reality that should be recognized, understood, and managed.

Risk and Return: An Inseparable Relationship

Marks emphasizes that the pursuit of high returns inevitably involves risk. If there were no risk, every investor would simply choose assets with the highest returns, and that would be the end of it. However, in financial markets, to achieve above-average returns, one must accept and manage risks. Therefore, the relationship between risk and return is inseparable—the greater the risk you are willing to take, the higher the potential for large returns, but also the potential for significant losses.

The key takeaway, according to Marks, is that investors must understand the type and level of risk they are taking on and determine whether these risks are acceptable based on their return expectations.

The Illusion of Safety

Another important point Marks addresses is the concept of "safety." Many investors fall into the trap of believing that there are assets entirely free of risk. This, according to Marks, is a misconception. Even investments considered "safe," such as government bonds, carry some degree of risk—whether it's the risk of inflation eroding returns or the risk of a government facing financial difficulties.

Marks warns against overconfidence in apparent safety and reminds us that everything carries risk to some extent. Therefore, it’s crucial to be aware and prepared for these uncertainties.

The Role of Risk Management

For Marks, the real challenge for investors is not to avoid risk but to manage it effectively. Risk management involves identifying, measuring, and mitigating the risks a portfolio is exposed to. This is where diversification comes in—an essential tool for reducing exposure to extreme events and increasing long-term success. However, Marks reminds us that diversification doesn’t eliminate risk; it simply distributes it more evenly.

Another vital aspect of risk management is building a margin of safety. This means purchasing assets at prices below their estimated intrinsic value, providing an additional buffer if things don’t go as planned.

How Smart Investors Handle Risk

Marks emphasizes that successful investors don’t shy away from risk—they embrace it in a calculated way. They understand that to achieve above-average returns, they need to invest in assets that carry greater uncertainty and risk but always with a disciplined approach. Smart investors constantly evaluate the balance between risk and reward and adjust their strategies based on changes in the market and the economic environment.

Conclusion: Risk as an Ally

Risk is an unavoidable reality for all investors, but as Howard Marks teaches us, it is also indispensable. The real challenge lies in learning to handle it intelligently and strategically. Investors who understand the nature of risk, accept its presence, and manage it effectively are better positioned for long-term success.

Rather than viewing risk as an enemy, we should see it as a necessary component for achieving superior returns, always with caution, diversification, and a solid risk management strategy. As Marks highlights, risk is part of the investor’s journey and the path to extraordinary results in the world of finance.