One of the best resources for investors are Howard Marks’ memos. One of our favorite memos here at The Acquirer’s Multiple is one he wrote called – Warning Signs in which Marks discusses the two main risks in the investment world.
Here is an excerpt from that memo:
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.
You can read the entire memo here.
For all the latest news and podcasts, join our free newsletter here.
Don’t forget to check out our FREE Large Cap 1000 – Stock Screener, here at The Acquirer’s Multiple:
