The Risk That Really Matters
Why permanently losing money is worse than watching your portfolio swing like a roller coaster
Understanding Risk
When people talk about investment risk, many immediately think of volatility. But in truth, that’s not the kind of risk that smart investors worry about most.
Most investors don’t shy away from an investment because of day-to-day price swings. What they fear is permanent capital loss, or ending up with an unacceptably low return after years of commitment.
That’s the real risk: losing money permanently. And the tricky part is that this kind of risk can’t be captured in a formula, because it depends on context, the economic cycle, and human behavior.
In theory, the only widely accepted metric for risk-adjusted return is the Sharpe ratio. But as Bruce Newberg put it:
“The probable doesn’t happen, and the improbable happens all the time.”
Risk is elusive. You can’t always spot it before investing, and often not even after. It only materializes in the future—when it’s usually too late to do anything about it.
Recognizing Risk
The first step to managing risk is recognizing it. And that begins by identifying moments when the market is paying too little attention to it.
When investors get overly optimistic and overpay for an asset, risk is rising. In fact, an environment where nobody is talking about risk is often the most dangerous one.
For the value investor, high risk and low return are two sides of the same coin—and the shared cause is usually overpriced assets.
Risk doesn’t always reside in low-quality assets. Even top-quality companies can be risky if bought at excessive prices. Because risk doesn’t lie in the asset itself, but rather in the price you pay for it.
A widely popular opinion is not only a source of potentially lower returns, but also of elevated risk. And when everyone believes there’s no risk at all, it’s probably when risk is highest.
Managing Risk
Measuring risk with precision is hard. Evaluating risk-adjusted return is even harder, especially in booming markets where everything seems to be working.
Great investors aren’t necessarily the ones who generate the highest returns. They’re the ones who achieve solid returns with much lower risk, or even slightly lower returns but with far better protection against losses.
As Warren Buffett famously said:
“Only when the tide goes out do you discover who’s been swimming naked.”
During bull markets, cautious investors might not shine. Their reward lies in knowing they have a robust risk management system, even if they don’t need it… yet.
Because risk is invisible, and the absence of losses doesn’t mean your portfolio is safe. Risk can silently creep into portfolios full of trendy assets bought at sky-high prices.
Taking risk isn’t inherently bad. It’s part of the game. But taking risk without realizing it is what usually proves costly.
Risk is always present. It only becomes visible when the environment changes and prices drop. That’s when losses show up. And if you weren’t prepared, those losses might never be recovered.
Conclusion: The Art of Protecting Capital
True long-term investment success doesn’t come from a few big wins—it comes from avoiding big mistakes. Your track record at the end of your investing journey will likely be shaped more by your worst investments and how bad they were, than by how incredible your best ones turned out to be.
That’s why the path to sustainable investing success is more about controlling risk than chasing aggressiveness. Because the most dangerous kind of risk… is the one you never see coming.
Source
The Most Important Thing by Howard Marks
Nice piece. I disagree with the penultimate paragraph though. Depends on position sizing. If equal sizing positions and stock A goes up 300% and stock B goes to zero, surely stock A contributes more to the portfolio. Coffee can portfolios usually end up with a few big positions and the failures become small positions.