Risky Business


Starting in late 2007, and continuing throughout the so-called Great Recession, conventional talking heads prophesized the end to America’s reign; tea leave readers foretold China’s economic belly flop; the European Union threatened to unravel, to be undone first by Greece, then Portugal, then Ireland, then Spain, then … and the all mighty consumer stopped spending thus greasing the downward spiral.

With eyeballs bugging out left and right, folks terrified of an impending crash landing fled financial markets. Too risky, too dangerous, they said. So equities were dumped en masse and shelter was sought under cover of Government Treasury Bills and mattresses.

And Now … The New And Improved America

Nearly a decade later, the American economy has healed. U.S. manufacturing is undergoing a renaissance, fracking has transforming the energy sector for better or worse, housing markets are humming, unemployment targets have been exceeded, and, as a matter of self-interest, global economies are cheering, and benefitting from, America’s phoenix like rise. Compared to the dark days, the financial world as we know it is at relative peace.

And in the wake of perceived macro economic risks falling by the wayside, stock market indices are hitting one new high after another. Feeling secure about domestic and global economic prospects, investors continue to pour record amounts of cash into equity index funds and mutual.

Seems like a smart move, yes? I mean, with systemic, default, credit, liquidity, operational and market value risk sirens no longer screaming, isn’t now the perfect time to get into the stock market, to shoulder more risk in exchange for higher return?

Reality Check

Risk. It’s double-sided. In the investing world as in life in general, risk may simultaneously present danger and opportunity. Yet, many people hear the word risk and run, as if it’s a fatal hazard to avoid. And sometimes it is. Sometimes, after plotting bar charts, measuring graphs, researching and analyzing, doing due diligence until the cows come home, we rightly conclude that the chance of potential harm outweighs any possible reward.

At other times (i.e., Great Recession), we get scared. Emotions drive decision-making. We panic and sell into downdrafts at a loss. Then we stand on the sidelines biting our fingernails, waiting for calm to return, convincing our self that we’re safer bearing the risk of not investing.

Are we safer on the sidelines when markets implode? Or we missing out, failing to capitalize on golden opportunities?

Fear of Loss May Equal Loss of Opportunity

When it comes to investing, emotions are your nemesis. When they take over, we become blind to unbiased data.

We minimize the fact that North America has experienced more than forty economic recessions during the past two hundred years. We overlook the reality that every one of those recessions came to an end, that the sun never stopped rising, and growth eventually resumed an upward trajectory.

Meaning? That recessions are part of the natural capitalist cycle, and that while extreme volatility has been known to cause shallow breathing and digestive issues, it may also be understood as a measure of temporary price fluctuation. Not loss (unless you sell at exactly the wrong time), but fluctuation. And these fluctuations often present opportunity for gathering low hanging fruit leading to juicy returns.

Mental Wonkiness

Why the persistent, near universal investor short sightedness? Why, without fail, does the appetite for equities decrease when markets are volatile and increase when markets are stable?

Blame one of the biggest risks of all, the risk residing between our ears, that conceptual notion called The Mind.

Embedded in the mind is fear, a primal emotion. According to behavioral finance’s prospect theory, fear saddles investors with what is called loss aversion, i.e., we place more weight on the pain associated with loss than the good feeling resulting from gain.

True, it’s only a theory. But just for fun, test it out. Ask yourself, what emotions did you feel back in 2007-2009 when reading successive month end statements showing lower and lower portfolio values? And when daily media reports gluttonously shared the feast of bad news how often did your stomach turn? Did those feelings make you want to buy stocks or bolt for the exit, courtesy of fear?

Fear overpowers the investor’s two most effective weapons: logic and rationality. Without these, we’re practically defenseless against the onslaught of panicky herds. And certainly, unlike Warren Buffet, we forget that market uncertainty may be our friend.

Profiting from Uncertainty

Late 2008, holding fast to the conviction that global capitalism wasn’t flat lining, Mr. Buffett wrote a cheque for the tidy sum of $5B to buy Goldman Sachs (NYSE:GS) preferred shares yielding a hefty ten percent (equals $500M/annually). At the same time, he buys warrants allowing for purchase of 43.5M common shares at $115.

Three years later, GS buys back the preferreds at a ten per cent premium (another $500M for Buffet; another day at the office) and, as of the time of this writing, GS commons trade near $215 making for a plus 90% value increase.

When most everyone else was sprinting to the bunkers, how could Buffett be sure that stock market declines were not a harbinger for the end of the world as the Mayans predicted?

Well, other than stating the obvious that hindsight is 20/20, I’m not going to pretend to have an answer. But I’ll go out on a limb and say that, as a student of history, Buffet knew the following:

  • Since the 1940s, the Dow Jones Industrial Average (DJIA) has declined by at least 20% more than 12 times;
  • Since 1906, the DJIA has been on an upward climb, moving from 100 to near 21,000; and
  • About every five years or so, there’s a temporary market pullback before resuming the march to new heights.

Related, I wouldn’t be surprised if Buffet’s faith in the upward trend of financial markets mirrored a similar faith in civilization as so eloquently stated by Franklin D. Roosevelt in 1945 (quoting Rev. Endicott Peabody, Roosevelt’s former teacher):

“Things in life will not always run smoothly. Sometimes, we will be rising toward the heights, then all will seem to reverse itself and start downward. The great fact to remember is that the trend of civilization is forever upward; that a line drawn through the middle of the peaks and valleys of the centuries always has an upward trend.”

Learning From The Giant

Though there will never be another Warren Buffett, we mere mortals may learn from him. During the next recession (a matter of time), investors would do well do pop an antacid or two and consider buying fundamentally sound, large cap, domestic and global companies that happen to get sideswiped by general hysteria.

As for today, some market indices are trading at or near record highs. For the most part, the easy money’s been made. So this brings us back to the question, is now a good time to buy equities?

Some say, yes, buy now. Others say the present day rotation into equities is little more than another chance for sheep to get fleeced. While a third investor subset isn’t so sure, believing there are still too many question marks and it would be best to wait for greater clarity.

The thing is, the future is never clear. So for investors, it’s more about injecting rational thought and sidestepping fear. It’s more about asset diversification and long term perspective, rather than timing purchases. Do this, and balance and wealth are bound to grow.