Howard Marks' secret to investing success

The greatest hockey player of all time, Wayne Gretzky, is often attributed as saying "You miss 100% of the shots you don't take". That must explain why he took more than 5,000 shots on goal in his legendary 20-season career. But no one, not even Gretzky, becomes the greatest in their profession (or just great, period) without taking a few risks.

As investors, we do it all the time. Choosing to make an investment in one firm over another, the risk of staying in cash versus being fully invested, small cap or large cap, Australia or overseas, stocks or alternatives, bonds or credit. The choices are endless - and so is the risk.

Indeed, the very concept of risk is the subject of Howard Marks' latest investor memo. Marks, the co-founder and co-chairman of Oaktree Capital Management, helps manage US$189 billion across credit, listed equities, and private equity strategies (three asset classes that are no stranger to risk). In this wire, I'll summarise the key insights from his latest memo (and harken to other recent memos he has written on this subject).

All good memos start with... chess

Marks begins his memo with a chess analogy. You cannot win a chess game if you don't have a plan to set yourself up in a winning position. That plan, Marks says, will inevitably involve giving up pieces in a bid to attract a more advantageous position.

"Many positions cannot be won or saved without something of value being given away," US chess grandmaster Maurice Ashley writes - with Marks adding "Intentionally losing a piece as part of one’s game plan is the sacrifice that Ashley is referencing."

Investors face the same sacrifices. For every dollar you can invest in one company, ETP, or fund, you give up investing that dollar in other products. While some sacrifices are very real, others are shams - like this example he provides on the world's benchmark for valuations:

"The analogy to investing begins to become clear. Buying a 10-year U.S. Treasury note is a modest or 'sham' sacrifice," Marks remarks. 

"You give up the use of your money for 10 years, but that’s only an opportunity cost, and accepting it brings the certainty of interest income. Most other investments involve real sacrifices, though, where the risk of loss is borne in pursuit of gains that are neither immediate nor tangible," he adds. 

And of course, as many of your fellow investors could probably tell you, the opportunity cost of not taking risk is, in itself, a big risk. Being that little bit braver meant you could have made a bundle in CSL (ASX: CSL) - instead of that term deposit that you decided to opt for instead. 

The three choices facing investors

Marks argues that investors, from a behavioural standpoint, often have to choose between one or two of the following:

a) Avoiding risk and having little or no return, 

b) Taking a modest risk and settling for a commensurately modest return, or

c) Taking on a high degree of uncertainty in pursuit of substantial gain but accepting the possibility of substantial permanent loss.

Marks goes on to add:

"Most investors are capable of accomplishing “a” and most of “b.” The challenge in investing lies in the pursuit of some version of “c."

In other words, to chase high returns, you must be willing to take real and significant risks! Investors must accept that losses or a period of underperformance will come as they pursue a longer, better period of outperformance.

"The risk inherent in not taking enough risk is very real. Individual investors who eschew risk may end up with a return that is insufficient to support their cost of living. And professional investors who take too little risk may fail to keep up with their client’s expectations or their benchmarks," he adds.

So what's his advice?

"Investors must accept that success is likely to stem from making a large number of investments, all of which you make because you expect them to succeed, but some portion of which you know won’t," he writes. 

"Not every effort will be rewarded with high returns, but hopefully enough will do so to produce success over the long term. But refusal to take risk in this process is unlikely to get you where you want to go." 

This isn't the first time he's written about risk

Marks has written about risk extensively in the past. In his previous memo entitled "Fewer Losers or More Winners", he writes:

"Not having any losers isn’t a useful goal. The only sure way to achieve that is by not taking any risk. But, as I said earlier, risk avoidance is likely to result in return avoidance. There’s such a thing as the risk of taking too little risk."

In another memo entitled "Easy Money", Marks spoke to the world we left relatively recently - a world where interest rates were ultra-low and risk-taking was happening at an excessive level:

"These investors become what my late father-in-law called 'handcuff volunteers' – they move further out on the risk curve not because they want to, but because they believe it’s the only way to achieve the returns they seek."

He went on to add that the craving that investors have for risk helped zombie firms and scams like FTX and Theranos to flourish. In the very last section of that long memo, Marks answered a question that a lot of investors are still asking - will we ever return to the easy money era? 

Many investors have already made up their minds (usually some combination of never, no, or not for a long time) but Marks argues that interest rates are not even high at the moment. And now, the current Fed knows what happens if they go too early (or even signal rate cuts too early):

"Cutting rates to stimulative territory as soon as inflation hits 2% could cause it to reaccelerate. Instead, the plan should be to get inflation to 2% and then keep rates at a level that is neither stimulative nor restrictive," he wrote.

Marks concludes that memo by guessing that the US interest rate will hover around 3% over the next five to ten years. And that is, as he emphasises, just a guess. No one knows what central banks will do next - not even the central bankers themselves. But what you know is what risk you can absorb and what risks you want to take.