“Introducing Howard Marks’ take on Risk vs Return.”
I will be the first to admit, I am a nerd at heart. Howard Marks is an investing legend and one of the founders of Oaktree Capital Management. I have read every one of his investment letters (1,500+ pages).
This chart could be the most unique and powerful concept he has introduced:
The typical Risk/Return graph we are taught is the straight line you see, up and to the right. As risk increases, the expected return increases as well. Simple and clean, like most things they teach us in economics. However, in reality, not so simple and clean (like most things in reality).
Marks adds the large bell curves intersecting vertically with the line. What these represent are the possible outcomes at each point of the graph. If we imagine the first bell curve (bottom left), low risk, low return, a US Treasury perhaps. It has a low range of possible outcomes. None of these include loss of capital or hitting a home run.
However, as we move farther to the right we have wider and wider possible outcomes. As we take on more risk, more things can happen. This is such a powerful concept. Too often we judge investments based on what happened. Not what could have happened. We hear about the guy who bought BTC or GameStop and retired, but not those who blew up. About the 100% financed SMB acquisitions that worked, but not those that declared bankruptcy.
History is written by and about the winners. This leads to survivorship bias. Our reality is formed by those who made it, not those who didn't.
Understanding this range of possible outcomes has made me more risk cautious. I do not say risk averse, because investing is, at its heart, taking on risk. I embrace it. At the same time, I build in certain controls to increase safety:
1. Buy what I understand
2. Respect my limit on multiple paid for a business
3. Keep my overall leverage low
4. Focus on negotiating favorable terms on that leverage
These 4 steps help narrow the range of possible outcomes and increase my chance of survival.