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This arti­cle is a guest con­tri­bu­tion by Howard Marks, CIO, Oak­tree Cap­i­tal Management.

Memo to: Oak­tree Clients
From: Howard Marks
Re: Warn­ing Flags

For about a year, I've been shar­ing my real­iza­tion that there are two main risks in the invest­ment world: the risk of los­ing money and the risk of miss­ing oppor­tu­nity. You can com­pletely avoid one or the other, or you can com­pro­mise between the two, but you can't elim­i­nate both. One of the promi­nent fea­tures of investor psy­chol­ogy is that few peo­ple are able to (a) always bal­ance the two risks or (b) empha­size the right one at the right time. Rather, at the extremes they usu­ally obsess about the wrong one . . . and in so doing make the other the one deserv­ing attention.

Dur­ing bull mar­kets, when asset prices are ele­vated, there's great risk of los­ing money. And in bear mar­kets, when everything's at rock bot­tom, the real risk con­sists of miss­ing oppor­tu­nity. Every­one knows these things. But bull mar­kets develop for the sim­ple rea­son that most peo­ple are buy­ing – ignor­ing the risk of loss in order to keep from miss­ing oppor­tu­nity – just when ele­vated prices imply losses later. Like­wise, mar­kets reach their lows because most peo­ple are sell­ing, try­ing to avoid fur­ther losses and ignor­ing the bar­gains that are everywhere.

The Never-Ending Cycle

Why do peo­ple buy when they should sell, and sell when they should buy? The answer's sim­ple: emo­tion takes over. Price increases excite investors and encour­age them to buy, and price declines scare them into selling.

When the econ­omy and mar­kets boom, peo­ple tend to assume more of the same is in the off­ing. They find lit­tle to worry about, other than the pos­si­bil­ity that oth­ers will make more money than they will. Fear of loss recedes, and fear of oppor­tu­nity costs takes over. Thus risk aver­sion evap­o­rates and risk tol­er­ance rises.

Risk aver­sion is absolutely essen­tial in order for mar­kets to func­tion prop­erly. When suf­fi­cient risk aver­sion is present, peo­ple shrink from riskier invest­ments and pre­fer safer ones. Thus riskier invest­ments have to appear to offer higher returns in order to attract cap­i­tal. That's as it should be.

But when peo­ple get excited about the prospect of easy money – even if from assets or invest­ment strate­gies that have become far too pop­u­lar, turn­ing into over­priced manias – they fre­quently drop their risk aver­sion and adopt risk tol­er­ance instead. Thus they swarm into the invest­ment du jour with­out con­cern for its ele­vated price and risk. This behav­ior should con­sti­tute an impor­tant warn­ing flag for pru­dent investors.

In the same way that expanded risk tol­er­ance accom­pa­nies appre­ci­ated asset prices and con­tributes to the risk of loss, so does risk aver­sion tend to rise in times of depressed prices, increas­ing the risk of missed oppor­tu­nity. When peo­ple refuse to buy assets regard­less of their low prices, they miss out on the best, lowest-risk returns of the cycle.

Recent His­tory – on the Upside

Just as the recent mar­ket cycle was extreme, so was the swing in atti­tudes regard­ing the "twin risks." And thus so are the resul­tant learn­ing opportunities.

Risk aver­sion was clearly inad­e­quate in the years just before the onset of the cri­sis in mid-2007. In fact, I con­sider this the main cause of the cri­sis. (Last year, Deal­Book, the online busi­ness pub­li­ca­tion of The New York Times, asked me to write about what I thought had been behind the cri­sis. My arti­cle, enti­tled "Too Much Trust, Too Lit­tle Worry," was pub­lished on Octo­ber 5, 2009. It offers more on this sub­ject should you want it.) Here's the back­ground regard­ing the early part of this decade:

Inter­est rates kept low by the Fed com­bined with the first three-year decline of stocks since the Depres­sionto reduce inter­est in tra­di­tional invest­ments. As a result, investors shifted their focus to alter­na­tive and inno­v­a­tive invest­ments such as buy­outs, infra­struc­ture, real estate, hedge funds and struc­tured mort­gage vehi­cles. In the low– return cli­mate of the time, much of the appeal of these asset classes came from the fact that they promised higher returns thanks to their use of lever­age, whether through bor­row­ing, tranch­ing or derivatives.

Given the high promised returns, investors for­got about (or chose to ignore) the abil­ity of lever­age to mag­nify losses as well as gains. Con­tribut­ing to investors' rosy view of leverage's likely impact was their belief that risk had been ban­ished by (a) the effi­cacy of the Fed and its "Greenspan put," (b) the com­bi­na­tion of secu­ri­ti­za­tion, dis­in­ter­me­di­a­tion, tranch­ing, decou­pling and finan­cial engi­neer­ing, and © the "wall of liq­uid­ity" com­ing toward us from China and the oil pro­duc­ing nations.

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