Howard Marks: Smart Investors: Manage Portfolios with Life Insurance Strategies

In Part 9 of his series on How To Think About Risk, Howard Marks compares risk management in investing to automobile and life insurance. Just as we buy car insurance for peace of mind regardless of whether an accident occurs, investors should manage risk without expecting to avoid it entirely.

Life insurance companies, though aware that policyholders will die, take risks they can analyze, diversify, and are well-compensated for. Similarly, skilled investors diversify and manage risk, aiming to achieve good returns while mitigating losses.

Marks emphasizes that risk control, not avoidance, is key to successful investing, as avoiding risk often leads to missed opportunities for returns.

Here’s an excerpt from the series:

I think the best model for investing and risk management is automobile insurance. We all drive, we all have cars, we all have insurance on our cars, but I don’t think any of us get to the end of a year and say, “I wish I hadn’t had insurance because I didn’t have an accident.” We like having insurance for the safety it gives us regardless of whether or not we have an accident in a particular year.

I think about the intelligent bearing of risk for profit. Back in 1981, I was interviewed by one of the first cable networks, and, uh, the reporter said to me, “How can you invest in high yield bonds when you know some of them are going to go bankrupt?” And for some reason, I was able to come up with the right answer on the spot.

I said, “The most conservative companies in America are the life insurance companies. How can they insure people’s lives when they know they’re all going to die?” And I think it’s an interesting question. But the life insurance company is, number one, taking a risk that it’s aware of.

They’re not shocked when somebody dies. That’s the way it goes.

Number two, they take a risk they can analyze. When I was a young man and got my first insurance policy, they sent a doctor to my house to see if I was healthy.

Number three, they take a risk that can be diversified. So no life insurance companies insure just smokers, or just people who live on the San Andreas Fault, or just skydivers, just young people, or just old people. They have a mix, a diversified portfolio. And they take a risk that they’re well paid to bear.

They figure out the probability of what they’re going to have to pay you based on actuarial assumptions, they allow some windage for the uncertainty, and then they charge you a premium.

We do the same. We take credit risk that we’re aware of. We analyze it. We take a risk that we can diversify. We have large numbers of holdings in every portfolio which respond to different factors, and it’s a risk we’re well paid to bear. We get what’s called a risk premium or a yield premium to take the risk of default.

So the bottom line is that I believe risk is kept under control in superior portfolios. That’s one of the things that superior investors do. Highly skilled investors assemble portfolios that will produce good returns if things go as expected and resist declines if they don’t.

This asymmetry is, in my opinion, the critical element — the cornerstone — of superior investing. Assembling a portfolio that incorporates risk control along with the potential for gains is a great accomplishment, but it’s often a hidden accomplishment because risk only turns into loss occasionally when the tide goes out.

But the prudent investor, and hopefully his or her clients, knows that risk is being controlled even at times when it doesn’t come to the surface.

So I think that risk is something to be managed and controlled, but not avoided. Risk control is indispensable; risk avoidance is not an appropriate goal in investing.

Will Rogers said, “You’ve got to go out on a limb sometimes because that’s where the fruit is.” I think, and my experience tells me from watching others, that risk avoidance equates to return avoidance. Intelligent bearing of risk should enable us to make good returns with the risk under control.

You can watch Part 9 of the series here: