The Thorn on Your Side: Howard Marks on Risk

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📝 CONTENT INFORMATION

  • Subject: Howard Marks’ writings on risk (2006-2025)
  • Source: Oaktree Capital Management memos
  • Key Memos: “Risk” (2006), “Risk Revisited” (2014), “The Indispensability of Risk” (2024), “Ruminating on Asset Allocation” (2024), “On Bubble Watch” (2025)

🎯 HOOK

Academics define risk as volatility. Howard Marks has spent two decades explaining why this is wrong, arguing that the only risk that matters is the possibility of permanent loss of capital.

💡 ONE-SENTENCE TAKEAWAY

Risk cannot be measured precisely, quantified in advance, or eliminated entirely, but it can be understood, respected, and compensated for if you replace mathematical models with experienced judgment and a clear definition of what you are trying to avoid.

📖 SUMMARY

Howard Marks, co-founder of Oaktree Capital Management, has written about risk for nearly two decades. His memos form one of the most thoughtful bodies of work on the subject.

Challenging the Academic Orthodoxy

In his 2006 memo “Risk,” Marks argued that academics settled on volatility as a proxy for risk “as a matter of convenience” rather than because it captures what investors actually care about. Volatility is quantifiable and works well in mathematical models, but it misses the point. Marks writes: “I’ve never heard anyone say, ‘I won’t buy it, because its price might show big fluctuations.’” What investors truly fear is the possibility of permanent loss of capital.

He identified several flaws in using volatility as a measure of risk:

  • A stock that goes from $50 to $80 has the same volatility as one that goes from $50 to $20, but the risk is clearly different.
  • A stock that rises steadily is considered low risk until it falls, after which it is suddenly considered high risk; this is backward.
  • Volatility relies on historical patterns, but the future is not guaranteed to resemble the past.

Redefining Risk

For Marks, risk is “the likelihood of losing money.” He later refined this to distinguish between temporary fluctuations and permanent losses. A downward fluctuation is not a problem if the investor can hold through it. A permanent loss occurs when the investor is forced to sell during a downturn or when the investment itself fails to recover.

Crucially, risk cannot be measured even after the fact. If you buy something for $10 and sell it for $20, was it risky? The novice says the profit proves it was safe. The academic says it must have been risky because you made 100%. Marks says it might have been either, you cannot know from the outcome alone. “The probability of loss is no more measurable than the probability of rain,” he writes. “It can be modeled and estimated, but it cannot be known.”

Beyond Permanent Loss

Marks recognized several other dimensions of risk:

  • Falling short of your goal: A retired executive needing 4% and getting 6% is fine. A pension fund needing 8% and getting 6% faces serious risk.
  • Benchmark risk: The best investors can have extended periods of underperformance. Warren Buffett in 1999 is the example, a refusal to participate in the tech bubble meant trailing the market, which was a badge of courage, not failure.
  • Career risk: When managers and owners are different people, managers may fear losses more than they value gains, since losses could cost them their jobs.
  • Unconventionality risk: Keynes observed that “it is better for reputation to fail conventionally than to succeed unconventionally.” The fear of being different often prevents investors from pursuing superior returns.

Coping with an Unknowable Future

Marks confronts what he calls “the essential conundrum”: investing requires us to decide how to position a portfolio for a future that is fundamentally unknowable. The future is influenced by too many factors, including unknown unknowns and randomness.

The solution is to view the future not as a single predictable outcome but as a range of possibilities with a probability distribution. Risk estimation becomes “the province of experienced experts” and is “by necessity subjective, imprecise, and more qualitative than quantitative.” Einstein said it: “Not everything that counts can be counted, and not everything that can be counted counts.”

The Indispensability of Risk

In his 2024 thinking, Marks explored a paradox: avoiding risk can itself be risky. Insufficient risk-taking may prevent investors from achieving their goals. The most important portfolio decision is selecting a targeted risk posture, the desired balance between aggressiveness and defensiveness. The goal should be optimization, not maximization: wealth pursued in a way appropriate to the investor’s wants and needs.

Bubbles as Risk Psychology

In his 2025 memo “On Bubble Watch,” Marks applies his framework to bubbles, arguing that a bubble is more a state of mind than a quantitative calculation. His famous three stages of a bull market capture this:

  1. A few insightful people see improvement ahead.
  2. Most people accept improvement is happening.
  3. Everyone concludes things can only get better forever.

The key ingredient that allows bubbles to form is newness. When something has no history, there is nothing to tether expectations. Investors convince themselves that “this time is different.”

🔍 INSIGHTS

  • The single most useful reframing for any investor is replacing volatility with permanent loss as the definition of risk. Most risk-management tools in modern finance are built on the wrong foundation.s
  • You cannot evaluate whether a decision was risky by looking at the outcome. A safe bet can get lucky; a risky bet can work out. Outcome analysis requires probability distributions, not binary results.
  • The “essential conundrum” (positioning for an unknowable future) is not a problem to solve but a condition to accept. The best risk managers do not try to predict; they prepare for a range of outcomes.
  • Career risk and unconventionality risk explain more bad investment decisions than any analytical error. Most professional investors are not paid to be right; they are paid to not be fired.
  • The three stages of the bull market provide a practical framework for identifying when risk has become mispriced. Stage 3 is not a quantitative signal, it is a psychological one.

📚 SOURCES

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