In The Most Important Thing Illuminated author and investor Howard Marks shares investment wisdom he has acquired over a lifetime. Many of his principles apply outside of the investment world.
A successful investor must learn to manage risk and return. Return is very easy to measure, but it is meaningless without understanding the underlying risk, which is not easily measurable. Sophisticated models which propose to measure risk usually fail because risk entails unknowns that evade measurement.
Our last financial collapse was largely about allowing a philosophical understanding of risk to be replaced by delusional mathematical certainty.
“The financial crisis occurred largely because never-before-seen events collided with risky, levered structures that weren’t engineered to withstand them.”
“Many investors- amateurs and professionals alike- assume the world runs on orderly processes that can be mastered and predicted. They ignore the randomness of things and the probability distribution that underlies future developments.”
Periods of success, in investments, economics, and in political policy can hide underlying risks. Years of terribly misguided housing policy hid the risks of the ensuring housing collapse. Thinking that housing could not decline in fact made it happen and investors, lenders and homeowners ignored risks.
Government policy created systemic risks by forcing common action through regulation.
It may be difficult if not impossible to predict hazardous occurrences, but it is not difficult to build structures that can withstand such unknown hazards. Loose money policies, systemic regulations, and policy makers largely ignorant of probabilities, however, created an environment that favored fragile structures. CEOs of Wall Street’s largest financial titans were equally blind to risks behind the returns that they thought were the result of their own genius, which vaporized as quickly as their returns.
Political structures are especially hazardous because politicians who enact bad policies get the credit and are rarely in office to face the consequences of their action. Furthermore there are large complex structures that can hide foolish polices sometimes for decades. Monetary policies can hide the consequences of foolish fiscal policies.
Creating stronger economic structures may decrease short term returns, but may make for far more sustainable growth. The desire to focus on the (political) return and ignore systemic risks is as seductive to politicians as it is for investors.