Feb 16, 2023
As we enter a new year and reflect on a rather tumultuous 2022, we feel compelled to discuss the topic of prudent risk taking. It seems as if we went from a period where it was easy to make money to one where it was very difficult – even the “safe” investments, such as bonds, didn’t work. We think it is important to explain that the markets work like a pendulum, swinging from excessive risk taking to excessive risk avoidance.
One would like to think markets are efficient, but as long as emotions are at play, the swinging pendulum of greed and fear will stay in motion
The saga of FTX is a great case study on excessive risk taking. We won’t go into the details of the debacle, but we can use this as an example of common investor behavior. This is nothing new – manias and bubbles go back hundreds of years. Just Google “Tulip Mania” and you will see the same story of excessive risk taking, just a different asset (not to be confused with “Tulip Time,” for our Holland, MI friends out there).
Great companies can still be bad investments if you invest with the masses during a bubble.
We have a tendency as humans to fear missing out on the next great thing, whatever that may be. Blockchain and Cryptocurrency are interesting technologies and may well have a meaningful place in our future lives; but the problem is when the masses start throwing money into new ideas without proper research and toss due diligence and prudent analysis out the window. Even worse, the company you invested in might not be all that you thought it was when you finally pull back the curtain.
When you feel flush with cash, you might be willing to take risks you wouldn’t typically take if you seriously depended on it to cover your basic needs.
These manias tend to also correlate with time periods where there is excessive liquidity (recently, the Fed’s low interest rate policy and the stimulus funds from the pandemic). Your mom would have said it’s like having money burning a hole in your pocket.
In the business of investing, seeing others getting rich quickly taps into our primal instinct that we might be missing out on something (but didn’t the Bible say not to covet your neighbors’ goods?). When multiple twenty-something college dropouts become millionaires overnight because they invested in some hip new ideas, you should probably question it a little more. This isn’t to say some of these enterprising youngsters haven’t merited the rewards (as many certainly have), but let’s not automatically place our unconditional faith in what they spout out, either.
Instead of “What am I missing?” ask: “What are investors not paying attention to that could get them in trouble?”
Bubbles self-perpetuate themselves as people see riches made easily, which becomes a magnet that attracts even more people onto the dogpile. It is usually about that time when things turn south…and they can turn south quickly! Let’s just put it this way, when celebrities start private equity funds or host seminars to invest in a certain asset class, it’s probably closer to the end of the run than the beginning (no offense to our favorite athletes and popstars out there).
What the wise man does in the beginning, the fool does in the end.
We must also add that these problems are worsened when debt is involved – as the last-to-the-party investors start questioning the merits of an investment, the asset values can turn south quickly, and those investors will find themselves in big trouble. When it comes time to settle their debts, the big “winner” they hoped would be used to pay it off is no longer worth what they thought. We all know what happens when underwater investments need to be sold quickly to cover these debts – fire sales. This is like everyone in the theater trying to rush out the one small exit door at the same time. Prices drop fast in a panic.
Even a low-risk asset can be a high-risk investment if you overpay (or use excessive leverage).
The point is that risk can take many forms. Common sense and prudence go a long way to decide if something is a wise investment – if it looks a little too easy for someone to get rich, it probably is. When new riches are made quickly, they can often be lost just as quickly. There’s a line in Hemingway’s novel The Sun Also Rises where a character is asked how he went bankrupt. “Two ways,” he answers. “Gradually, then suddenly.” Asset price selloffs can feel much the same way.
It’s critical that we approach risk taking with a careful eye. You must protect yourself – there are no sure things out there (as much as we might think something is a “slam dunk” deal). Prudent investment due diligence is a good start, but you also need to diversify. Know your limits. If you don’t fully understand how an investment works and how you will ultimately make money on it (p.s. hoping the price just keeps going up doesn’t count), it’s OK to pass on it. Warren Buffett calls it “putting it in the ‘too hard’ pile.” Oftentimes, it’s not that you aren’t smart enough, it’s that the actual investment is clouded with opaque language and features that are intentionally hard to understand.
Don’t confuse the appearance of “sophistication” with “superior” investment opportunities. Sometimes it’s the simplest idea that can pay off the in the long run.
At NPF, our goal is to keep our clients’ money safe so it can bring returns for the many years ahead. Having the right plan and knowing when to accept the right amount of volatility in exchange for reasonable long-term returns is the goal. We feel privileged to be able to help each of our clients in that process. To learn more about how NPF can help you build the right portfolio and investment strategy tailored to your needs and goals, please reach out.
