The market’s appetite for risk is a lot like a young Hollywood romance: it goes through nauseating cycles of on and off. The market undergoes a crisis, breaks up with risk, and stocks fall. Eventually, the healing of economies and the return of corporate profitability helps the market to forget the past and resume its relationship with risk. Everything seems wonderful until the relationship becomes obsessive and unhealthy again, prompting yet another breakup. This dynamic is volatile but as natural to capital markets as it is to Twilight fans.
Investors who crave excitement and unrewarded risk are better off going to Vegas. Unfortunately, it is hard to stick to this principle – be boring! – when markets go on a tear.
Looking back over 2013, markets appear to have changed their temperament with risk. Equity valuations now appear at or above long-term averages. Synthetic products like Collateralized Debt Obligations, the very structures that helped to undermine the fi nancial system in the last recession, are beginning to re-emerge. Even Cinda, the state-backed bank in China that takes on bad Chinese loans, was able to go public with huge interest from investors who were trying to gain exposure to those bad loans.
Investors today are increasingly reaching for yield and choosing lower-quality investments in return.
The reality is this: successful investing is boring. Prudent investing is about managing risks and achieving objectives through a disciplined, systematic process. Investors who crave excitement and unrewarded risk are better off going to Vegas. Unfortunately, it is hard to stick to this principle – be boring! – when markets go on a tear.
In this kind of environment, an investor can get carried away with the exciting and the novel. But when markets get excited, your best bet is to be boring. Instead of taking on more debt, pay down that mortgage. Hedge some of your expenses. And, as you consider what to do with your investment portfolio, ensure that your decisions are being made with a sensible, long-term process in mind.
Like all bad romances, the market’s infatuation with risk is likely to go on for much longer than any prudent investor desires. Investors can choose to go along for the wild ride, or they can opt for a little peace of mind and be boring. The latter is a lot less likely to result in heartbreak and much more likely to result in investment success.