“Time honoured bromides” on risk from Howard Marks:
The market awards appropriate risk premiums – The truth is that investors’ risk-averseness fluctuates between too much and too little. When it’s the latter, scepticism and conservatism dry up, due diligence is inadequate, risky deals are easy to pull off, and compensation for risk bearing usually turns out to be insufficient.
Riskier investments produce higher returns – This is one of the greatest of the old saws, and one of the wrongest. A collection of low-risk investments can produce a high return if the low-risk character of the components permits them to perform dependably and keeps there from being any big losers to pull down the overall result. On the other hand, high-risk investments can’t be counted on for high returns. If they could, they wouldn’t be high-risk. The presumed positive relationship between risk and return is predicated on the assumption that there’s no such thing as investment skill and value-adding decision making. If markets are efficient and there’s no skill, it’s reasonable to believe that higher returns can be attained only through the bearing of increased risk.
Adding risky assets to a portfolio makes it riskier – One of Nobel prize-winner William Sharpe’s greatest contributions to investment theory came with the realization that if a portfolio holds only low-risk assets, the addition of a risky asset can make it safer. This happens because doing so increases the portfolio’s diversification and reduces the correlation among its components, reducing its vulnerability to a single negative development.
Sometimes the outlook is clear, and sometimes it’s not – Truth is, the future is never worry-free. Sometimes it seems to be, because no risks are apparent. But the skies are never as clear as they seem at their clearest. Which is more treacherous when everyone understands that the future presents risks, or when they believe it to be knowable and benign?
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