Signup for our free newsletter:

Safely Increasing your Risk Tolerance

Written By Briton Ryle

Posted September 3, 2014

Want to be a more successful stock investor? In your search for sound investment advice from professional traders and financial advisors, don’t forget to also have a little chat with your friendly country farmer down the road. He or she can give you one of the wisest investment tips of all… don’t put all of your eggs into one basket. risk and reward

The biggest single mistake made by self-directed investors is putting too heavy a concentration of money into too few stocks, often only one. A recent survey by SigFig Wealth Management found that “1 in 4 investors has more than 23% of their worth in a single stock”.

“Investors who put a big chunk of their money into a single stock exhibit a fragrant mix of hubris and amnesia,” the firm adds. “Stocks of individual companies—even big, seemingly unsinkable ones—can and do go to zero. Goodbye, Enron! Sayonara, Washington Mutual!”

Enron, you may recall, was a major electricity, natural gas, communications, and pulp and paper company which by the year 2000 grew to become the fourth largest company in the United States. Fortune magazine even named it “America’s Most Innovative Company” for six consecutive years.

As it turned out, the only innovation the company developed was a creative way of hiding debt in offshore shell companies, as well as over-inflating its revenues and asset values. But of course, investors were bedazzled by the company’s soaring stock price. Just about everyone was shocked when the Enron empire came crashing down, highlighting the importance of investment diversification.

There are plenty of parallels in today’s market linking it to past bubbles and crashes, with plenty of high flying stocks just soaring up the charts like Enron once did.

Are investors suffering from market amnesia?

They say market-memory generally lasts five years or so, with investors destined to repeat past mistakes every handful of years. That’s pretty much where we are right now, isn’t it? Some five to six years after the 2001-03 crash came the 2008-09 implosion, and here we are some five to six years after that.

Is market amnesia affecting your investment decisions? Has the recent slow and steady uptrend over the past five years lulled you into a false sense of security? Perhaps causing you to let your guard down and venture away from the safety of balanced diversification toward a riskier over-concentration into high fliers?

You’d be surprised at how market-memory differs between newer and older investors. And it all centers on how much experience we have.

Market Memory is Fading

In their book “Investor Behavior – The Psychology of Financial Planning and Investing”, economists H. Kent Baker and Victor Ricciardi explain how a market crisis can be “seared into the collective investor memory”.

“The implications … are likely to be substantial and … will last years,” the economists explain. “This belief is supported by the long recovery period following a financial crisis (Reinhart and Rogoff, 2009).”

Just how does the collective memory of a major financial crisis affect investment behavior? “The financial crisis of 2008-2009 with its 50 percent drop in stock market value” has caused a “move away from equities into perceived lower risk fixed income by certain investor groups (Klement and Miranda, 2012),” the book answers.

In the aftermath of the last crisis, risk gave way to caution, with many investors leaving the market all together. “A major market change caused by the financial crisis is the alteration of the investor population,” the economists add. “Many investors had never experienced a financial crisis and suffered large losses, and thus have exited the market. Consequently, a different group of investors with different preferences and risk tolerance populate the post-crisis market.” Those who remained turned ultra-cautious.

This more cautious investment sentiment was “reflected in weak initial public offerings (IPOs) and merger volumes”, the book recounts the first few post-crisis years. Although stock values were rising steadily, there was substantially less money chasing after stocks, which meant not enough demand for new stocks through IPOs, and less excess value for companies to expand through M&A.

However, that overly cautious stance has recently changed. How do we know? By the flood of IPOs and M&A activity over the past two years. The Federal Reserve’s low interest rate policy pretty much forced investors back into equities, since bond yields are so horribly low. This created an oversupply of cash in the market chasing after the same number of stocks, thereby inflating stock prices.

This oversupply of cash flooding into the market naturally resulted in the expansion of the supply of stocks through IPOs as new companies simply could not resist the prices they could get for their shares.

In turn, the rising prices of stocks inflated company valuations, increasing their wealth and purchasing power, which spurred the wave of mergers and acquisitions we still see today, along with increased activity of stock buy-backs.

Can we see what has been happening? Caution has been slowly giving way to increasing risk tolerance. “Experience-based risk tolerances are time varying,” Baker and Ricciardi explain. “The self-reinforcing price impact will trigger pro-cyclical waves of optimism and pessimism, which affect perception and the overall price of risk as reflected in the equity risk premium and asset allocation decisions”.

Now there’s a mouthful. Simply put, investors’ comfort with risk varies as time passes, which affects not just stock prices, IPOs and M&A activity but also “asset allocation”. Investors – both individual and institutional – have been slowly lowering their guard and changing their allocations toward greater risk.

How is Your Market Memory?

This, of course, does not mean a severe market crash is imminent. Remember that the current bull run is being sustained by a Federal Reserve that wants to see more money enter equities to help companies recover after the harshest recession in 80 years. This bull run still has many years to go, with some analysts putting us in the sixth year of twenty, meaning we are still in this game’s third inning.

What the increasing level of risk tolerance in the marketplace does mean, however, is that we need to take a look at our asset allocation and see just where our risk is. That depends on your market-memory.

“Malmendier and Nagel’s (2011) generational-based collective memories hypothesis suggests the investor impact, while not permanent, is likely to be long term as memories only gradually decay after a major event such as the recent financial crisis,” the book highlights. “The greatest impact of this crisis is likely to be on generation Y due to the primary effect. Individuals who are 40 or older tend to be less responsive to negative economic shocks (Guiliano and Spiimbergo 2009).”

It all comes down to investment experience. If all you have lived through is one financial crisis, you are likely to be far too conservative for years to come, which could severely hamper your investment growth. “Behavioral memory biases have distorted generational probability assessments,” the economists caution, “and the impact on their long-term portfolio returns is substantial.”

If we are relatively new to investing with just one financial crisis under our belt, we need to take our heads out of our shells or risk damaging our “long-term portfolio returns”.

However, at the same time we mustn’t be forgetful of past crises so as to repeat the same blunders that crushed investors in the past – such as piling too many of our eggs into one or two high flying stocks.

Barnaby Cardwell, CEO of Cardwell Investment Technologies, reminds us of the danger of being lulled to sleep by the market’s unusual calm, only to be rudely awakened by a sharp correction:

“The markets always continue to surprise, and when markets become calm it is amazing how quickly they can become volatile again. A prime example was the global credit crisis starting in July 2007. Prior to this, the world was experiencing low volatility in long-term bullish stock markets slowly creeping upwards. Everything seemed great.

“However, volatility fluctuations became increasingly more prevalent towards mid-July with emerging problems in the credit markets. From then on, the picture got worse with a meltdown occurring through 2008. This was after years of low steady volatility and rising stock markets.”

Analysts are still very surprised at the exceptionally low market volatility in the market today, as indicated by the VIX falling to levels not seen in decades. Things have been too quiet and too smooth for too long.

Spread Those Eggs

Investors, therefore, need to be balanced in their investment approach, not just when it comes to properly spreading their money across multiple asset classes, but also when it comes to their own individual market-memory.

We don’t want to remember just the crisis alone and hide in low-yielding Treasuries, yet we don’t want to forget it either, to the point of being lulled into complacency thinking that everything will just keep going up and up and up without pausing or correcting.

This is the value of years of experience, which allows us to put the current phase of the market into the broader market perspective. If you’re concerned you don’t have that much experience yet, don’t worry. Experience is a dividend that time never stops paying.

Joseph Cafariello