Thursday, August 27, 2009
Here is the 16 page hedge fund letter from Howard Marks of Oaktree. It contains some pretty good insights. Below is an excerpt:
Something for Everyone
One thing that caused a lot of people to lose money in the crisis was the popularization of investing. Over the last few decades, as I described in “The Long View” (January 2009), investing became widespread. “Less than 10% of adults owned stocks in the 1950s, in contrast to 40% today.” (Economics and Portfolio Strategy, June 1, 2009). Star investors became household names and were venerated. “How-to” books were big sellers, and investors graced the covers of magazines. Television networks were created to cover investing 24/7, and Jim Cramer and the “Money Honey” became celebrities in their own right.
It’s interesting to consider whether this “democratization” of investing represented progress, because in things requiring special skill, it’s not necessarily a plus when people conclude they can do them unaided. The popularization – with a big push from brokerage firms looking for business and media hungry for customers – was based on success stories, and it convinced people that “anyone can do it.” Not only did this overstate the ease of investing, but it also vastly understated the danger. (“Risk” has become such an everyday word that it sounds harmless – as in “the risk of underperformance” and “risk-adjusted performance.” Maybe we should switch to “danger” to remind people what’s really involved.)
To illustrate, I tend to pick on Wharton Professor Jeremy Siegel and his popular book “Stocks for the Long Run.” Siegel’s research was encyclopedic and supported some dramatic conclusions, perhaps foremost among them his showing that there’s never been a 30-year period in which stocks didn’t outperform cash, bonds and inflation. This convinced a lot of people to invest heavily in stocks. But even if his long-term premise eventually holds true, anyone who invested in the S&P 500 ten years ago – and is now down 20% – has learned that 30 years can be a long time to wait.
The point is that not everyone is suited to manage his or her own investments, and not everyone should take on uncertain investments. The success of Bernard Madoff’s Ponzi scheme shows that even people who are wealthy and presumed sophisticated can overlook risks. Might that be borne in mind the next time around?
At Ease with Risk
Risk is something every investor should think about constantly. We know we can’t expect to make money without taking chances. The reason’s simple: if there was a risk-free way to make good money – that is, a path to profit free from downside – everyone would pursue it without hesitation. That would bid up the price, bring down the return and introduce the risk that accompanies elevated prices.
So yes, it’s true that investors can’t expect to make much money without taking risk. But that’s not the same as saying risk taking is sure to make you money. As I said in “Risk” (January 2006), if risky investments always produced high returns, they wouldn’t be risky.
The extra return we hope to earn for holding stocks rather than bonds is called an equity risk premium. The additional promised yield on high yield bonds relative to Treasurys is called a credit risk premium. All along the upward-sloping capital market line, the increase in potential return represents compensation for bearing incremental risk. Except for those people who can generate “alpha” or access alpha managers, investors shouldn’t plan on getting added return without bearing incremental risk. And for doing so, they should demand risk premiums.
But at some point in the swing of the pendulum, people usually forget that truth and embrace risk taking to excess. In short, in bull markets – usually when things have been going well for a while – people tend to say, “Risk is my friend. The more risk I take, the greater my return will be. I’d like more risk, please.”
The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so . . . and risk compensation will disappear. This is a simple and inevitable relationship. When investors are unworried and risk-tolerant, they buy stocks at high p/e ratios and private companies at high EBITDA multiples, and they pile into bonds despite narrow yield spreads and into real estate at minimal “cap rates.”
In the years leading up to the current crisis, it was “as plain as the nose on your face” that prospective returns were low and risk was high. In simple terms, there was too much money looking for a home, and too little risk aversion. Valuation parameters rose and prospective returns fell, and yet the amount of money available to managers grew steadily. Investors were attracted to risky deals, complex structures, innovative transactions and leveraged instruments. In each case, they seemed to accept the upside potential and ignore the downside.
There are few things as risky as the widespread belief that there’s no risk, because it’s only when investors are suitably risk-averse that prospective returns will incorporate appropriate risk premiums. Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we’ll continue to be alert for times when they don’t.
Read the whole letter here
10:15 pm | 
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