How Howard Marks' advice on risk can help investors in the small, mid-cap spaces

Everyone would love a shot at earning big gains with little risk, said Marks.

Much has been written, spoken, and discussed about risk in relation to investing, making oft-repeated age-old mantras like "no risk, no reward" sound like empty platitudes.

No matter how it is phrased or worded, in his latest memo to investors, Howard Marks of Oaktree Capital made one thing certain: risk is indispensable.

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Investors who've been burned in the recent blaze in small-caps and mid-caps, as well as first-timers looking to invest in stocks could do well to look up at Marks' latest memo to understand the relation between risk and returns.

There are three ways an investor can deal with an uncertain future, according to him. The first, one can avoid risk and earn little or no returns at all, while the second is taking modest risk and settling for a rather modest return. The third, and least adopted option, is "taking on a high degree of uncertainty in pursuit of substantial gain but accepting the possibility of substantial permanent loss".

All investors who participated in the SMID rally wanted a shot at making big gains at small risks. However, Marks said, believing it would negate the "efficiency of the market". Simply put, this means other participants in the markets aren't "dummies".

How Howard Marks' advice help find high returns in the SMID universe?

Marks said that success is likely to stem from making a large number of investments. An investor could make the investments in the expectation that they will succeed, but know that not all of them will.

He pointed to the success of Berkshire Hathaway to bolster his theory. According to Marks, the success behind Warren Buffett comes from his investments that performed well, a small number of big winners that he has invested heavily in and held for decades along with some relatively few big losers.

While Buffett had made a large number of investments, his success came from a select few.

Therefore, to earn high returns, an investor needs to bear meaningful risk.

By taking meaningful risk, you could either lose all your capital in attempting to gain or see underperformance while attempting to outperform, Marks said. Even in not taking risk, there is some  inherent risk as returns will be underwhelming, he pointed out.

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"You have to take a shot. Not every effort will be rewarded with high returns, but hopefully enough will do so to produce success over the long term," said the Oaktree Capital co-chairman.

There is one more thing investors looking for outsized gains in small and midcap shares ought to keep in mind: taking risks doesn't automatically ensure success. And that is the paradox of risk ."That’s why they call it risk," said Marks.

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