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The Thorn on your Side: Howard Marks on Risk

Living With Risk

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The Thorn on your Side: Howard Marks on Risk

Introduction

In the world of investing, few concepts are as crucial yet as misunderstood as risk. For decades, Howard Marks, co-founder of Oaktree Capital Management, has been one of the most thoughtful voices on this subject, challenging conventional wisdom and offering profound insights through his legendary memos. Spanning from 2006 to 2025, Marks' writings on risk form a treasure trove of wisdom that every serious investor should study. This article synthesizes his key insights on risk, showing how his thinking has evolved while maintaining a consistent core philosophy that stands in stark contrast to much of modern financial theory.

Challenging the Academic Orthodoxy: Risk vs. Volatility

The Fundamental Critique

In his seminal 2006 memo "Risk," Marks launched a direct assault on what he calls the "academic's choice for defining and measuring risk": volatility. He argued that academicians settled on volatility as a proxy for risk "as a matter of convenience" rather than because it captures what investors actually care about. Volatility is quantifiable and "machinable" which is perfect for mathematical models, but it fails to address the real concerns of investors.

Marks' critique is devastating in its simplicity: "I've never heard anyone say, 'I won't buy it, because its price might show big fluctuations,' or 'I won't buy it, because it might have a down quarter.'" Instead, he argues that what investors truly fear is "the possibility of permanent loss of capital."

The Problems with Volatility as Risk

Marks identified several critical flaws in using volatility as a measure of risk:

  1. Directional Blindness: A stock that meanders from $50 to $80 has the same statistical volatility as one that goes from $50 to $20, but few would argue they carry the same risk.
  2. Backward Thinking: A stock that rises steadily is considered low risk, but if it falls suddenly, it's suddenly labeled high risk—this is precisely backward.
  3. Historical Reliance: Volatility measures typically look at historical patterns, but "the future will not necessarily be like the past."
  4. Limited Value Addition: "No value is ever added through extrapolation" of past volatility into the future.

Redefining Risk: The Possibility of Permanent Loss

The Core Definition

For Marks, "risk is, first and foremost, the likelihood of losing money." This definition seems simple, but it carries profound implications for how investors should think about and manage their portfolios.

In his 2014 memo "Risk Revisited," Marks deepened this definition by distinguishing between temporary fluctuations and permanent losses. A downward fluctuation "doesn't present a big problem if the investor is able to hold on and come out the other side."

A permanent loss, however, "can occur for either of two reasons:

  1. 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
  2. The investment itself is unable to recover for fundamental reasons


The Unquantifiable Nature of Risk

Perhaps Marks' most profound discovery is that risk cannot be precisely measured, neither before nor after the fact. He demonstrated this with a simple example: "If you buy something for $10 and sell it a year later for $20, was it risky or not? The novice would say the profit proves it was safe, while the academic would say it was clearly risky, since the only way to make 100% in a year is by taking a lot of risk. I'd say it might have been a brilliant, safe investment that was sure to double or a risky dart throw that got lucky."

This lead to Marks' conclusion: "The probability of loss is no more measurable than the probability of rain. It can be modeled, and it can be estimated (and by experts pretty well), but it cannot be known."

Beyond Permanent Loss: The Multiple Dimensions of Risk

While permanent loss of capital is Marks' primary definition of risk, he recognized several other important dimensions that investors must consider:

1. Falling Short of One's Goal

Risk is relative to individual needs and circumstances. As Marks explained, "A retired executive may need 4% per year to pay his bills, whereas 6% would represent a windfall. But for a pension fund that has to average 8% per year, a prolonged period returning 6% would entail serious risk."

2. Underperformance and Benchmark Risk

Many investors face "benchmark risk" the possibility of underperforming a benchmark index. Marks noted that "the best investors can have some of the greatest periods of underperformance. Specifically, in crazy times, disciplined investors willingly accept the risk of not taking enough risk to keep up." He cited Warren Buffett in 1999 as an example, where underperformance was "a badge of courage, because it denoted a refusal to participate in the tech bubble."

3. Career Risk

This is "the extreme form of underperformance risk." When money managers and money owners are different people, managers may fear losses more than they value gains, "since losses could cost them their jobs." As Marks put it, "risk that could jeopardize return to an agent's firing point is rarely worth taking."

4. Unconventionality Risk

Marks referenced John Maynard Keynes's observation: "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." The risk of being different often prevents investors from pursuing superior returns that require unconventional approaches.

The Unknowable Future and Risk Management

The Essential Conundrum

In "Risk Revisited," Marks confronted what he calls "the essential conundrum": "investing requires us to decide how to position a portfolio for future developments, but the future isn't knowable."

He explained why the future is fundamentally unpredictable:

  • We're aware of many factors that influence future events, but they're hard to predict
  • The future can be influenced by "unknown unknowns"—events not on anyone's radar
  • There's too much randomness at work in the world
  • The connections between causes and effects are too imprecise and variable

Coping with Uncertainty

While we can't predict the future, Marks argued that "not being able to know the future doesn't mean we can't deal with it." The solution is to view the future "not as a fixed outcome that's destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution."

This leads to Marks' practical approach to risk management: "Risk estimation has to be the province of experienced experts, and their work product will by necessity be subjective, imprecise, and more qualitative than quantitative (even if it's expressed in numbers)."

He wisely cited Albert Einstein: "Not everything that counts can be counted, and not everything that can be counted counts."

Visualizing Risk: Probability Distributions

Beyond the Traditional Risk-Return Graph

One of Marks' most valuable contributions is his critique of the traditional risk-return graph that shows a straight "capital market line" sloping upward to the right. He argued that this graph is deceptive because "it communicates the positive connection between risk and return but fails to suggest the uncertainty involved."

A Better Representation

Marks proposed a more helpful visualization that shows probability distributions around expected returns. In his 2024 memo "Ruminating on Asset Allocation," he illustrated this concept with two key curves:

  1. Ownership assets (stocks, private equity, real estate): These have "a higher expected return, greater upside potential, and greater downside risk." The probability distribution is wider, reflecting greater uncertainty.
  2. Debt instruments (bonds, loans): These have "lower expected returns but likely to fall within a much tighter range." There's generally no upside. No one should buy an 8% bond expecting to make more than 8%, but also relatively little downside if the borrower performs.

This visualization perfectly captured Marks' definition of risk: the wider the distribution of possible outcomes, the greater the risk (possibility of permanent loss).

The Indispensability of Risk: A Paradox

Risk as Necessary

In his 2024 thinking, Marks explored what might be called "the indispensability of risk" the paradox that avoiding risk can itself be risky. Insufficient risk-taking may prevent investors from achieving their financial goals.

The Fundamental Portfolio Decision

Marks argued that "one decision matters more than (and should set the basis for), all the other decisions in the portfolio management process. It's the selection of a targeted 'risk posture,' or the desired balance between aggressiveness and defensiveness."

This leads to what Marks called "the fundamental, inescapable truth in investing": "You can't simultaneously emphasize both preservation of capital and maximization of growth, or defense and offense."

The goal, therefore, should be "optimization, not maximization." It shouldn't be "wealth," but "wealth pursued in an appropriate way, taking into account the investor's wants and needs."

Bubbles: Risk Psychology in Action

Bubbles as Psychological Phenomena

In his January 2025 memo "On Bubble Watch," Marks applied his risk framework to understanding bubbles. He argued that "a bubble or crash is more a state of mind than a quantitative calculation."

For Marks, bubbles are characterized by:

  • Highly irrational exuberance
  • Outright adoration of subject companies or assets
  • Massive fear of being left behind (FOMO)
  • Conviction that "there's no price too high"

The Three Stages of the Bull Market

Marks' framework for identifying bubbles included his famous "three stages of the bull market":

  1. Stage 1: Only a few unusually insightful people can imagine improvement after a decline.
  2. Stage 2: Most people accept that improvement is actually taking place.
  3. Stage 3: Everyone concludes that things can only get better forever.

It's in Stage 3 that risk becomes most dangerous, when psychological factors cause investors to ignore the possibility of permanent loss.

"This Time Is Different"

Marks identified the key ingredient that allows bubbles to form: "newness." When something is new, "there's no history to serve as a tether, keeping a favored group grounded on terra firma." Without historical context, investors can convince themselves that "this time is different" and normal rules don't apply.

This is precisely when risk (possibility of permanent loss) becomes most dangerous, when investors abandon the discipline of historical perspective and rational analysis.

Practical Implications for Investors

1. Redefine Your Understanding of Risk

Stop thinking about risk as volatility and start thinking about it as the possibility of permanent loss. This shift in perspective will fundamentally change how you evaluate investments.

2. Accept the Limits of Quantification

Recognize that risk cannot be precisely measured. Focus on qualitative assessment and experienced judgment rather than false precision from mathematical models.

3. Target Your Risk Posture

Make the level of risk in your portfolio a conscious decision, not an unintended consequence. The most important portfolio decision is determining your balance between capital preservation and growth.

4. Use Probability Distributions

Think about investments in terms of ranges of possible outcomes, not single expected returns. The wider the distribution, the greater the risk.

5. Watch for Bubble Psychology

Be alert to the psychological signs of bubbles: irrational exuberance, FOMO, and the belief that "this time is different." These are often the best indicators of elevated risk.

6. Embrace Second-Level Thinking

Marks has long advocated "second-level thinking" going beyond the obvious to consider what others might be missing. This is especially crucial in risk assessment, where conventional wisdom is often wrong.

Conclusion

Howard Marks' writings on risk span nearly two decades, but his core insights remain remarkably consistent and relevant. He provided us with a framework that is both more realistic and more useful for practicing investors.

His emphasis on the unknowable nature of the future, the importance of psychology in investing, and the limitations of quantitative models offers a counterbalance to much of modern financial theory. Marks reminds us that investing remains fundamentally a human endeavor, requiring judgment, experience, and psychological insight.

Perhaps Marks' greatest contribution is his insistence that risk management is not about eliminating risk (that's basically impossible) but about understanding it, pricing it properly, and ensuring that the potential returns adequately compensate for bearing it. In a world where the future is fundamentally unknowable, this is the most any investor can hope to achieve.

As Marks might say, the goal isn't to avoid risk entirely, but to be well compensated for the risks you take. And to never forget that the possibility of permanent loss is always present, even when it seems most remote.


Sources

Official links to these memos are available on Oaktree Capital Management’s website:



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