Mastering the downside

The rational investor is diligent, skeptical and appropriately risk-averse at all times, but also on the lookout for opportunities for potential return that more than compensates for risk. That’s the ideal. But in good times, we hear most people say, “Risk? What risk? I don’t see much that could go wrong: look how well things have been going. And anyway, risk is my friend—the more risk I take, the more money I’m likely to make.”

Then, in bad times, they switch to something simpler: “I don’t care if I ever make another penny in the market; I just don’t want to lose any more. Get me out!”

Now that we’ve moved on from considering cycles in the abstract to discussing their operation in the investment world, I’m going to provide a brief aside regarding the fundamental nature of investing, in order to establish a foundation for the discussion that will follow. Some of this admittedly will be familiar from earlier chapters.

What is investing? One way to think of it is as bearing risk in pursuit of profit. Investors try to position portfolios so as to profit from future developments rather than be penalized by them. The superior investor is simply someone who does this better than others.

Do we know what will happen in the future? Some investors think they do—or think they have to act as if they do, because if they don’t they’ll lose their jobs and their clients—or they have been pursuing profit through forecasts for so long that they’ve brainwashed themselves into believing it’s possible to be right about the future (and have become conditioned to ignore their low past success rates). Other investors—the smarter, more self-aware ones, I think—understand that the future isn’t knowable with certainty. They may form opinions regarding future events, but they don’t bet heavily that those opinions will prove correct.

Since risk (that is, uncertainty with regard to future developments, and the possibility of bad outcomes) is the primary source of the challenge in investing, the ability to understand, assess and deal with risk is the mark of the superior investor and an essential—I’m tempted to say the essential—requirement for investment success.

Finally as to foundation, it’s important to recognize that while the investment environment varies over time, at any particular point in time it is a given. What I mean is that we can accept the environment as it is and invest, or we can reject it and stay on the sidelines, but we don’t have a third option of saying, “I don’t like the environment as it is today; I demand a different one.” Or rather we can demand another, but of course that won’t make it materialize.

My view that risk is the main moving piece in investing makes me conclude that at any given point in time, the way investors collectively are viewing risk and behaving with regard to it is of overwhelming importance in shaping the investment environment in which we find ourselves. And the state of the environment is key in determining how we should behave with regard to risk at that point. Assessing where attitudes toward risk stand in their cycle is what this chapter is about—perhaps the most important one in this book.

This is an extract from Howard Marks' Mastering The Market Cycle published by Houghton Mifflin Harcourt