In a front page article on the initial public offering (“IPO”) boom in today’s (i.e., Monday, 5/13/13’s) Wall Street Journal, authors Telis Demos and Matt Jarzemsky lead off with
“U.S. companies are on track to raise the most money through initial public offerings since before the financial crisis, driven by the same thirst for risk among investors that has pushed the stock market to new highs.” (Emphasis mine)
Interesting wording here… “thirst for risk”…and an opportunity to elucidate some basic investing and financial theory and practice.
No one has a thirst for risk. We are all risk averse, to varying degrees, in the sense that we must be paid to take on additional risk. People don’t actively seek risk for the sake of seeking risk. They seek return. But with such expected return comes risk. I use the gerundive “expected” to modify return because the return is not assured; if return were assured, where would be the risk?
People are indeed thirsting for return due to the efforts of Fed Chairman Bernanke and his henchmen to dry up the investment landscape. Cash yields nothing so people turn to bonds. Bond yields drop so people turn to dividend paying stocks and so on. So people are satisfying their thirst for yield, or return, by taking on more risk. The risk is a necessary, but unwelcome, byproduct of quenching one’s thirst for return. People are willing to take on more risk, but only because they have to, in order to achieve the return they seek.
The problem is that risk is very difficult to measure. Technically, we measure it by the standard deviation of a sample, but that is so much academic gobbledygook to most investors, both individual and professional. To them, risk is much like air…nebulous, ever present, taken for granted, and difficult to measure. Brokers, banks, and other financial service providers often provide handy dandy questionnaires designed to assess clients’ and potential clients’ tolerance for risk, but, while these surveys claim to be scientific, they are, at least in yours truly’s opinion, largely bogus and designed to further the interests of the financial services provider rather than the client.
So risk is nearly impossible to measure, but even more problematical is that our assessment of our tolerance for risk varies with market conditions. We tend to overestimate our tolerance for risk when markets are strong and underestimate our tolerance for risk when markets are weak. In plain English, we buy when we should be selling (when we overestimate our tolerance for risk and pay prices that are therefore too high) and sell when we should be buying (when we underestimate our tolerance for risk and sell at prices that are too low).
Since we are currently in a period when a parched investing, or even just saving, public is desperately seeking return, and the markets are reacting accordingly (i.e., stocks are at or near record highs and yields are at or near record lows), it seems that investors are overestimating their tolerance for risk and paying prices that are too high.
Does this mean that bonds are rich? Yes. (See my 5/9/13 post, OF 10 YEAR TREASURIES AND STEAMROLLERS: RICH MARKETS CAN, AND DO, STAY RICH and the posts to which it will refer you.) Does this mean that stocks are rich? Maybe. Does this mean that we should all sell? Not necessarily; even if markets are rich (and we can never be sure), they can stay rich for a very long time; again, see my 5/19 post.
The best course, as my readers are tired of hearing, is to (from that 5/19 post again)
Hold some stocks, hold some bonds, hold some precious metals, and hold some cash. Dollar cost average if you can. REBALANCE REGLIGIOUSLY. Let the market do what it’s going to do. Leave the trading to those who can do it…and those who think they can do it. Let them provide the liquidity you need to function as a long term investor.
This will force you to do some buying when markets are cheap and selling when markets are rich, even though, trust me, doing so will be the last thing you want to do at the time.
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