Howard Marks, Chairman of Oaktree Capital Management, appeared on Bloomberg TV's "Market Makers" with Erik Schatzker and Stephanie Ruhle today, where he spoke about his new memo and the current market rally, saying "we're between the bottom of the seventh and the top of the eighth." Marks said, "It's time for the seventh inning stretch. I think you have to have plenty of defense on the field today. And most people are sitting on a lead, and when you have a lead you send in the defense specialists."
Marks said that "every investor faces two risks" and "...the question is which should you worry about more today, losing money or missing opportunity? I'd put some more emphasis on worrying about losing money today than I do about missing opportunities because I don't see such great opportunities that I have to worry about."
STEPHANIE RUHLE: Surely you've heard this line before. If you want to make more money investing, take more risk. Fine. Great even, if you understand what risk actually means. Howard Marks says most people don't, and he should know. He's the chairman of Oaktree Capital and one of the greatest investors in distressed debt. Howard, welcome back. Your newest letter is out. Tell us, what don't people understand?
HOWARD MARKS, CHAIRMAN, OAKTREE CAPITAL MANAGEMENT: The main thing people don't understand is that it's wrong to say if you want to make more money, take more risk. This is what people say. Higher -- riskier -- riskier investments have higher returns. So if you want to make more money, take more risk. It can't be right, Stephanie.
RUHLE: Why?
MARKS: Because if riskier could be counted on to produce higher returns, they wouldn't be riskier. It's at simple as that. There's got to be something wrong with that formation. What we should say is that investments that appear riskier have to appear to offer higher returns or nobody will make them. But that doesn't mean it has to come true. And lots of things other -- lots of things can happen other than what you hope will happen.
ERIK SCHATZKER: Is it also true that investing in riskier instruments increases your chances of higher returns but also of higher losses?
MARKS: Exactly, exactly. That's -- that's the thing that people have to understand. Yes, when you take on more risk you expect a higher return, but you should also understand --
SCHATZKER: Hope for a higher return.
MARKS: You hope, yes, but you should also understand that the range of possible outcomes becomes wider. With T-bills there's no uncertainty. With the five-year there's a little uncertainty. With corporates there's a bunch. With stocks there's more. The more risk you take, the more uncertain the outcome is, and the worse the bad ones are.
SCHATZKER: You've got a good information for this, right? You have -- you have -- and you show this in your most recent letter what the traditional model of risk versus return looks like versus the -- I won't call it the Marxist model, but the Marx model of risk versus return, and this is what it looks like. So what are you showing us here?
MARKS: Well on the left you have -- thank you for doing that. On the left you have the normal presentation which shows that as risk goes up return goes up. On the right you -- you have the same line but superimposed on it at each point is a probability distribution, Bell-shaped curve turned on its side. So as you can, as the risk goes up as you move from left to right, the return goes up, yes, the line slopes up to the right. But at the same time, the distributions become wider, the range of outcomes becomes greater, and the bad ones become worse. And eventually on the risky investments, if you get a bad outcome you lose money. That's what risk is.
SCHATZKER: So what does this explain to us about investor behavior and the performance of financial markets?
MARKS: Well, what it explains I think is that people put themselves -- they try to make more money by taking more risk. When things go well, they make more money.
SCHATZKER: As they are now.
MARKS: As they are now. As they -- they tend to conclude, that means that riskier assets produce higher returns and they go out for even more risk and eventually they find out about the other part of that drawing.
RUHLE: What's the difference between volatility and risk? Because oftentimes people lump them together and they don't actually mean the same thing. Volatility is a temporary fluctuation. Risk in my opinion is permanent loss. So in other words, everybody had a big decline in the crisis of '08. By the end of '09, most things were back to where they had been. If you didn't sell in the crisis, you didn't crystallize that loss.
You -- you experienced the fluctuation but you didn't turn it into a permanent loss by selling. And that's really the key. Can you hold on through? Do you have the nerve? Do you have the conviction? Do you have the financial staying power? Are you going to not be fired by your clients? But volatility is relatively benign. It doesn't feel that way at the time, but it's benign if you can hold on.
SCHATZKER: Howard, you have summarized your views on what risk is in four key points, and I think we've got them together in a graphic so we can walk through them to help people to understand the point that you're trying to make. First of all, you say the future shouldn't be viewed as a fixed outcome but a range of possibilities. Why is that important?
MARKS: You shouldn't think you know what's going to happen.
SCHATZKER: But so many people do.
MARKS: Well, but they're wrong.
SCHATZKER: They're professional prognosticators.
MARKS: Exactly. That's an oxymoron. Mark Twain said it ain't what you don't know that gets you into travel. It's what you know for certain that just ain't true.
RUHLE: One more time?
MARKS: It's not what you don't know that gets you into trouble. It's what you know for certain that just ain't true. If you think you know something and act in certitude and turn out to be wrong, that's how you lose a lot of money. If you say I'm really not sure what's going to happen, I'm going to hedge my bets and diversify my portfolio, you're less likely to get into trouble.
RUHLE: You've said before you never say never.
MARKS: Well you never say never and you never always.
SCHATZKER: So your point number two, risk means more things can happen than will happen.
MARKS: Well that's the point. Everybody says what's going to happen to interest rates next year? What's going to happen to GDP next year? Everybody will give you a number, but the point is even if you're -- even if you think you know what is the most likely outcome and even if you're right, lots of other things can still happen. And you have to allow for the uncertainty that is present in the world in the world and you have to prepare your portfolio. The people that got into real trouble in '08 were the people who couldn't hold on through that downward fluctuation and who had set themselves up for success and when a little failure showed up they had to sell out. So they sold out at the bottom and they didn't participate in the recovery.
SCHATZKER: Some of them were forced to sell though.
RUHLE: So they shouldn't have been there to begin with.
MARKS: That's right. They shouldn't have had a portfolio which circumstances could force them to have to make sales.
SCHATZKER: Or liquidity requirements (inaudible).
RUHLE: Then you shouldn't have been in that asset class.
SCHATZKER: Hey, I'm not disagreeing with you. I'm just saying that there are people who make investments in risky assets who are forced to meet in some cases monthly liquidity demands.
MARKS: Absolutely. That's --
SCHATZKER: That's pretty -- that -- that feels like a bit of a mismatch.
RUHLE: But then maybe they shouldn't be in an asset class where they're forced to have those liquidity demands (ph).
MARKS: Now having said that, Stephanie, that introduces one of the great conundrums in investing. Because what you said is you should be -- you shouldn't hold asset classes that -- that you -- where you'd have to sell if things go wrong. How bad could it get? Do we have to be prepared every day for a rerun of '08? In that case nobody would hold anything. So again, you have to look at it as a probability distribution. You might want to prepare for the middle of the probability distribution, but sometimes you get into the tails.
SCHATZKER: Is that what you mean by point number three? Knowing the probabilities doesn't mean you know what's going to happen.
MARKS: Well -- well done, Erik.
RUHLE: I feel like we're in Howard Marks -- I feel like we are in --
SCHATZKER: I told you it was going to be a master class.
RUHLE: It is like a master class today.
MARKS: And you get an A. If you -- we may know that the Dow going to 2,000 at the end of next year is the most likely single outcome, but still lots of other things can happen. And you have to prepare for some of those. Also, you might have to prepare for the possibility that it'll go to 2,300 -- 23,000 or that it'll go to 14,000. But you can't prepare for everything because then you're in a muddle.
RUHLE: Okay. So your point number four. Many things can happen but only one will. What (inaudible) figure out the highest probability.
MARKS: See, the first quote came from a professor at the London Business School, Elroy Dimson, who said more things can happen than will happen. That's risk. I like to turn it around. Lots of things can happen. Only one will. So --
SCHATZKER: How does that guide your behavior as an investor? You have -- look, let's just establish for people your track record, right? You started with a high-yield bond fund at Citigroup in 1978 and now you sit atop --
RUHLE: When he was 14.
SCHATZKER: How much does Oaktree have in assets today?
MARKS: $91 billion.
SCHATZKER: $91 billion of mostly fixed income assets thanks to an unbelievable track record as an investor. So all of this, all of these rules about what risk is and how to understand it have led you to make certain decisions. What -- what are the most critical decisions that an investor can make having -- having understood this?
MARKS: Well I think it's very -- the most important single thing an investor has to do is decide on whether to play mostly offense or mostly defense at a point in time. And I think we've done that pretty well. And we -- we --
SCHATZKER: What's the right thing to do now?
MARKS: I think a little more -- I think not a little. I think more emphasis on defense than offense.
RUHLE: Really?
MARKS: I think that every investor faces two risks. Now if I say to you, Erik, what are the two risks, you'd get an A if you say the main one is the risk of losing money. But if you want to get an A plus you have to say the second one, and that is the risk of missing opportunity.
RUHLE: Fear of missing out.
MARKS: Now -- now the problem is we have the risk of losing money and the risk of missing opportunity, and you can eliminate either one.
RUHLE: How?
MARKS: Well if you want to not lose any money, go into treasuries. But then you miss all the opportunities. If you say I don't -- I want to be sure I don't miss any opportunities, then we'll put you into all kinds of exciting stuff but no treasuries. And then you're really in the cross hairs if something bad happens. So the answer is we balance the two, right? And you have to figure out at a point in time how to balance the two, which one to emphasize. So the question is which should you worry about more today, losing money or missing opportunity? I'd put a little -- I'd put some more emphasis on losing -- on worrying about losing money today than I do about missing opportunities because I don't see such great opportunities that I have to worry about.
SCHATZKER: Howard --
RUHLE: At $91 billion they figured out -- he figured out (inaudible).
SCHATZKER: Figured out a few things. Quite often when you come here we talk about the baseball analogy. We're in a risk asset rally. And if we think about the rally in terms of nine innings, the last time you were here you, if I recall correctly, you thought maybe sixth inning, getting into seventh inning. Where are we now?
MARKS: Well we're between the bottom of the seventh and the top of the eighty.
SCHATZKER: So we're getting close to the end of the game.
MARKS: It's time for the seventh inning stretch. I think -- I think -- I think you have to have plenty of defense on the field today. And most people are sitting on a lead, and when you have a lead you send in the defense specialists.
SCHATZKER: The irony of course is that pain for everybody else often means opportunity for you.
MARKS: Yes, that's right. And we are -- we'd love to get some better opportunities to buy stuff. Today there's no -- there's no distressed. There are very few defaults. There is nobody who feels any urgency to sell. There are no meltdowns. There's no financial pressure to sell. So how can we get any pronounced bargains? We need some of that stuff, which means we have -- we need the world to go less well.
RUHLE: Howard, it is always a pleasure having you here. Such a treat. Today's master class was an absolute success. Oaktree's Howard Marks joining us this morning.
