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Pro Management With Howard Marks | Understanding Risk to Survive Crypto Markets
In life, the risks associated with a decision are not always a determining factor in the outcomes. In trading, it is. For traders, risk is a paramount concept, depicting the actual price to pay for the rewards they expect, which means investors' rewards are proportional to the risk they bear. Howard Marks believes that risk represents the potential for loss during investment. Cryptocurrencies are not an exemption from this.
Understanding Risk
Between making a decision and expecting an outcome, there is always a consequence to take. What is that consequence? The chance of being right or wrong about the decision.
If a person decides to buy a product from an online shop, it expects the product to arrive in the quality promised by the shop according to the price already paid, but when the merchandise arrives at its door, the product is not what it should be.
Casually, this person goes to the mall and discovers a similar product of better quality and price that fulfills their needs and buys it. Now, this person can decide to dispense with the low-quality product, preserve it, or resell it.
In any case, the question here is:
- Did this person lose something?
- If it did, what did it lose?
In the process of buying online instead of in a physical shop:
- Was the risk of being wrong the consequence assumed?
- Could this person avoid that risk?
Regarding the products:
- What role did the prices play in this hypothetical situation?
- Was the risk of receiving a low-quality product the paid price for shopping comfortably from home instead of going to the mall first?
All those are legitimate questions. This article offers a guide to understanding risk in trading according to Howard Marks's lessons on this subject.
What is Risk? Howard Marks Definitions
Howard Marks defines risk from the standpoint of how to think about it rather than what to think it is. Such an idea let us with two ways to address his definition:
- Risk is the ultimate test of an investor's skill.
- Risk is all probability of loss.
Since Marks sticks with the notion of how instead of what regarding risk, each of these two descriptions addresses crucial aspects of investment and trading:
- The first belongs to the management side.
- The second refers to risk in terms of volatility.
Managing Risk According To Howard Marks
For Howard, returns are not an isolated metric and should not be the only criteria for measuring how adequately traders and investors manage a portfolio. Instead, the core factor is understanding how much risk a manager bears to reach his return.
Let's overview some scenarios that delineate some management styles and potential repercussions:
Return | Management | Value |
| A manager could harvest a return of 12% in a bull market and then get down -12% when the market retraces. | The manager swings with the market, which every index already does. | From this scenario, there is nothing to seize. |
| Other traders generate up to 18-20% when the same bull market is up 12% and proportionally down -18-20% when the market retraces. | The aggressiveness characterizes this scenario. | There is nothing more than aggressiveness. |
| A conservative investor might gain 5% in the same markets and be down -5% later. | Now, this is just a defensiveness manager. | Just defensiveness. |
| Some managers amass 15% when the market is up 10%, then lose -10% along with the market. | In this case, there is a positive asymmetry: | 5% remains. |
| Finally, wiser managers may earn 10% when the market is up 10%, then lose -5% as the market declines 10%. | In this case, there is a negative asymmetry: | 5% remains still, not by gaining more but by losing less while preserving the profits. |
Volatility, Asymmetry, And Attending Risk In Crypto Markets
Howard Marks believes the risk is not volatility but a "symptom of the presence of risk." This relationship between both concepts can help crypto traders as it establishes critical points that may serve the managing and surviving needs in front of the volatility that characterizes cryptocurrency markets.
Marks also thinks that risk is unquantifiable. However, volatility is. Crypto traders may see risk as a symptom arising from uncertainty about the course of an outcome in the future, while volatility is a consequence of that uncertainty.
Traders can not expect to know how much risk they will bear when placing an order, as the future is always unknown. A stop-loss is not precisely a measure of risk, and there are various reasons to state this:
- A trader could enter the market with a defined SL and start winning immediately. There is no risk of losing part of the balance if the trader rapidly places the SL to break even.
- The current equity is now positive in a 1:2 risk-reward ratio.
- Should the trader take profit? What about "the risk of leaving money on the table"?
- Should the trader let it run? What about "the risk of losing the current profit"? What is the cost of opportunity associated with it?
Proper management can attend to all those concerns and is vital during investment, especially in crypto, where volatility can invalidate a thesis overnight. The asymmetry is the formula for the long run.
Asymmetry Vs. Risk-Reward Ratio: A Better Formula For The Long Term
Risk-reward ratios are not the wrong approach. After all, swing traders and intraday strategies rely on it. However, asymmetry is a more efficient concept for measuring the efficacy of management for months and years.
A legend like Paul Tudor Jones has spoken about it, and as exposed in a prior section of this article, it reflects the value added to an investment or a trading season.
While RR ratios tell traders how much they lose and win in a single operation, asymmetry reveals the returns harvested and unveils the manager's performance.
Conclusion
Risk is the cornerstone of every trader and investor for proper management and the price they pay for pursuing a capital return. While investors demand compensation in the form of profit, they must accept a consequence in the probability of loss.
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