The normal explanation of risk is price volatility. But true risk increases when
we do not act according to market conditions.
The natural and automatic tune of most investors is to chase assets when they are
hot and when their prices are soaring. Furthermore, investor mood gets a kicker
when markets are euphoric, but turns gloomy when prices are down.
Have you ever wondered why investors do this? Why do people like soaring markets,
and not the other way round? That’s because it’s natural to like green
in one’s portfolio. But time after time, investors get so carried away looking
at these paper profits that they make bigger investments when the markets are too
high. People dislike the declines. They do not buy stocks when prices are low worrying
that share prices are going to go down further, thus lose out on opportunities to
accumulate. An investor’s emotions can be her biggest enemy.
This is ironic, and leads to erroneous actions, and it tends to increase investing
risk. A true investor’s psychological mood should be this: happy when stock
prices are dipping, and sad when they are soaring.
Value investing guru, Howard Marks, rightly states in one of his interviews, “It’s
the swings of psychology that get people into the biggest trouble, especially since
investors’ emotions invariably swing in the wrong direction at the wrong time.
When things are going well, people become greedy and enthusiastic, and when times
are troubled, people become fearful and reticent. That’s just the wrong thing
to do.”
The fundamental building block of investment theory is the assumption that investors
are risk averse, continued Marks. “But in reality, they are sometimes very
risk averse, and miss a lot of buying opportunities, and sometimes very risk tolerant
and buy when they shouldn’t. Risk aversion is constant or dependable.”
One of the foundations of getting basic investing right is to understand the concept
of risk vis-a-vis the application of human emotions in the markets. The traditional
yardstick of risk measures swings in asset prices such as equities. If these are
sharp and swift, asset prices are thought to be more risky. But, of course, risk
goes beyond that. Investor psychology has to factor in the reactions to the price
of an asset class.
It is this psychology that often steers us towards chasing assets that are rising
in prices and avoiding those that are down. This basic investor mentality sometimes
gets people into trouble—buying into assets that are too high priced, and
vice versa. This by itself, and our psychological reactions, tends to increase the
risk levels of one’s portfolios.
Asset markets do what they are supposed to do. People think that they can time the
markets when their emotions are ruling investment decisions. The idea that one can
get out just in time is a false one. Hence, our reactions to market movements have
to be moderated and controlled.
Volatility is an integral part of the market, and these days even more so as global
and domestic economic and social factors are closely inter-twined. In the investment
world, investors are constantly battling with their emotions and it is driven by
short-term factors. This should be seen as real risk, rather than volatility.
Warren Buffett in his latest annual letter to shareholders also dismisses the conventional
definition of risk. “…. That lesson has not customarily been taught
in business schools, where volatility is almost universally used as a proxy for
risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong:
Volatility is far from synonymous with risk.”
People often fail to assess why they are investing in a particular asset class,
and where it will lead them into the future, not just on price movements. Superior
investors are those who can understand the moods of the markets, and control their
reactions to them. The battle between greed and fear is won in the minds. By applying
principles of time and value, i.e., buying with a longer time horizon and a low
purchase price, investors can build a portfolio that’s relatively less risky.
When emotions get in the way, people tend to go overboard with their assumptions.
A classic example is when oil hit nearly $150 back in July 2008. Everybody thought
that oil prices were going to go higher, probably even closer to $200. Almost everybody
back then had a bullish view on oil prices. Nobody said that oil prices would fall
to where it is today: $45 per barrel.
The bottom line is that risk is a function of price. Howard Marks said that if you
focus on price you could buy a consumer company and lose money, or you could buy
a distressed real estate company and make money.
Superior investors are those who understand that asset prices are constantly going
to be in and out of favour and move up and down, but the investing results is bound
to be much better when you can buy when there is pain in the market.
This article was also published in Mint on 24th August 2015.