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Howard Marks: Is Risk a Function of Security Quality?

Low-quality stocks are conventionally considered "high risk," while popular blue-chip stocks are considered "low risk." Similarly, investment-grade bonds are considered "low risk," while junk bonds are considered "high risk." But is this actually true in all cases? In his book, "The Most Important Thing," investor Howard Marks (Trades, Portfolio) explained where the risk of capital loss stems from, and why it is not actually a question of "quality."

Where does risk come from?

Before talking about where risk comes from, however, it is important to explain where it does not come from. Specifically, poor quality securities are not always risky. Risk is not a measure of investment quality, it is always a relative measure that has to incorporate the price paid for the asset:

"Risk of loss does not necessarily stem from weak fundamentals. A fundamentally weak asset-- a less-than-stellar company's stock, a speculative-grade bond or a building in the wrong part of town -- can make for a very successful investment if bought at a low-enough price."

Another commonly attributed source of risk is broader market conditions. It is a commonly held notion that investments made during volatile times, or during a bear market, are inherently more risky than those made during a bull run. Not so:

"Risk can be present even without weakness in the macroenvironment. The combination of arrogance, failure to understand and allow for risk, and a small adverse development can be enough to wreak havoc. It can happen to anyone who doesn't spend the time and effort required to understand the processes underlying his or her portfolio."

In fact, once we understand that risk is a relative measure that is sensitive to price, it becomes clear that the risk of loss is actually greater during highly priced bull market runs. By paying a higher price in good times for the same security than you would in bad times, you are taking on more risk. Many market participants do not understand this, largely for psychological reasons:

"Mostly it comes down to psychology that's too positive and thus prices that are too high. Investors tend to associate exciting stories and pizzazz with high potential returns. They also expect high returns from things that have been doing well lately. These souped-up investments may deliver on people's expectations for a while, but they certainly entail high risk."

In efficient markets, risk and return are balanced out. Now, while markets are efficient most of the time, we certainly know that that is not true all the time. Value investors believe that it is possible to achieve high return and low risk together. These opportunities are usually found in unpopular stocks, bonds or other assets:

"Dull, ignored, possibly tarnished and beaten- down securities -- often bargains exactly because they haven't been performing well -- are often the ones value investors favor for high returns. Their returns in bull markets are rarely at the top of the heap, but their performance is generally excellent on average, more consistent than that of 'hot' stocks and characterized by low variability, low fundamental risk and smaller losses when markets do badly."

This type of security will most likely underperform the market during exuberant bull runs. But that seems like a small price to pay for the knowledge that your capital will be safer during the bear periods. Make sure you guard yourself against losses, and the gains will look after themselves.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.