When Human Behavior Changes the Perception of Risk
During bear markets, or “normal” market times most people view risk as the potential to lose money in an investment. During times of euphoria, the view of risk changes from that core to viewing risk as the fear of missing out.
Every so many years the economy hits an economic recession that generally coincides with negative returns for most investments generating fear amongst those involved. This experience teaches us to perceive risk as potential for loss and has a dampening effect on most investors' appetite for risk.
After a strong bull market, memories of loss fade, and stories about ordinary investors getting rich off speculative investments proliferate. This idea snowballs through the investing public via FOMO (fear of missing out) and the perception of risk is transformed. Greed sets in and irrationally tells us that risk should be perceived as failing to grow as rich as those around us. If that greed isn’t suppressed, it causes investors to take on excessive risk in pursuit of unreasonably high returns. Collectively, this rapacious behavior leads to asset bubbles and the inevitable pop is disastrous for those involved (tech and telecom bubble of the late 90s, the housing bubble of the mid-2000s are recent examples).
Risk is still risk, and if viewed incorrectly you can put yourself into a situation where you are taking on more than you bargained for. The problem with this is that you won’t realize you have taken on as much risk until it is too late.
“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”
― Warren Buffett
As investors, it can be very difficult to do as Buffet instructs. When fear and panic sweep the market causing prices to plunge, we should be greedy looking for opportunities because quality investments are on sale. The problem is, our emotions as humans make this a difficult step. It can be scary to invest hard-earned savings as the market seems in freefall. History shows us that those periods of time tend to create tremendous opportunities. As FOMO sets in, we must resist the urge to buy trendy investments at unreasonable prices. This is the time to take extra precautions to ensure your risks are calculated. Avoid jumping on bandwagons.
There are plenty of trendy investments that turn out in the short-term more like Nikola (NKLA) than turn out to be Tesla (TSLA). For every meme stock or cryptocurrency that we think may be the next Amazon (AMZN) the odds are much greater that it is the next JDUniphase..... You likely won’t know or remember the name of the latter, which is the point!
Only the most disciplined will stick with their investment plan. However, psychologically it is much easier to be opportunistic buyers after a steep market decline if you didn’t participate in the greed at the top. Our role as your Advisor and Wealth Manager at Aurora Financial Strategies is to ensure that you are taking an appropriate amount of risk in your own accounts and attempt to avoid the common pitfalls associated with investing. We’ve written something similar to this before, check it out by clicking here. Plainly stated, emotions get in the way when it comes to investing. This is true during times of market decline (selling something too early because you don’t like seeing your account balance decrease), and in times of rapid growth (taking risks you otherwise wouldn’t for the fear of missing out on something big).
Benjamin Graham teaches us that the difference between investment and speculation is a margin of safety. Investing as a discipline requires a margin of safety, or buying an asset for less than what it is worth after careful study of financial statements and making conservative estimates for the future.
At the moment, many are participating in speculation which eschews the margin of safety principal and seeks quick gains on trendy assets. There is something called the greater fool theory that underpins asset bubbles. The primary reason an investment is purchased is the idea that it can be sold to “a greater fool” for even more money. This works for a while creating the FOMO effect but eventually, there is no “greater fool” and investors look to sell at the same time. When the asset price is falling the idea of buying it to sell to someone higher seems less sound, causing a steep decline that can wipe out most of people’s savings. In other words:
The door to get in may be wide open. If you stay too long, the door is awfully tiny on the way out (with everyone attempting to leave at the same time)!
And that sets the cycle all over again.
Billy Cardwell, CFP® and Austin Crites, CFA
Billy Cardwell and Austin Crites are the President and Chief Investment Officer or Aurora Financial Strategies, a financial advisory firm based out of Kokomo, IN. and can be reached via email at billy@billycardwell.com or austin@auroramgt.com. Investment Advisory Services are offered through BCGM Wealth Management, LLC, a SEC registered investment adviser. This blog does not constitute advice. This is not an offer to buy or sell securities. Advisor is not licensed in all states.
