There are dozens of different types of risks and biases that investors need to consider when making investment decisions. Some such as market risk, concentration risk, credit risk, liquidity risk and time horizon risk are easier to quantify and are well understood. Others such as recency bias, confirmation bias and herd mentality are more nuanced and require some self-reflection to mitigate or offset their impact.
Share markets have been kind to investors over the past several months, and our portfolios have enjoyed solid returns on the back of this. However, the recent buoyancy in share markets has not changed my underlying cautiousness regarding the risks that investors face. I still think the world is precariously placed, even though the share market doesn’t seem particularly concerned now. Wars can escalate, inflation may not be over, the list goes on.
Investors have become complacent and seem to ignore any potential for bad news. Rather than factor in risks more conservatively, the share market has taken an attitude that everything is great until it has been proven that it is not. This binary thinking isn’t very smart because it doesn’t account for the reality that there are indeed risks that exist with varying degrees of probability. These risks need to be factored in.
To make the math simple, let’s imagine there are 2 separate global events, event A and event B. Let’s further assume each event has a 50% probability of occurring in the next 12 months and would result in a 20% decline in the share market. Based on the probability of each of the 2 events happening, the following outlines the combination of possible outcomes and their probabilities of occurring:
1. 25% chance that neither event A nor event B occur.
2. 50% chance that either event A or event B occurs.
3. 25% chance that both event A and event B occur.
Unfortunately, investment markets often misprice event risk. Perhaps it is due to complacency or the intangible nature of assessing risk. Nevertheless, in the absence of an event occurring, the default assessment of these risks by investors in the current market seems to be to ignore it until it happens.
This might turn out to be ok in the 25% chance where neither of the 2 events occurred. But that results in a mispricing of risk until that point because there was a 75% chance of a negative outcome whereby at least one of the events occurs. If the events do occur markets need to adjust much more aggressively. In the basic scenario I outlined above, there is a 50% chance that one or the other event occurs, resulting in a 20% fall. While there is also a 25% chance that both events occur leading to a much larger fall in the share market.
In reality, there are many risks at play of varying probability and consequence. But in today’s complex geopolitical and global economic environment, where there are many more event risks than usual, the prudent assessment of risk is imperative. It’s critical to think differently and ensure you don’t get caught up in the herd mentality as markets throw caution to the wind. Consider the way various biases impact your thinking and assessment of risk.
So, while investment markets and many investors seem to have taken a head in the sand approach to considering these risks, I am happy to carefully consider them. It means that we continue to take profit from time to time as share markets go ever higher. We want to be prepared for the day when one or more of these events do occur because eventually, they will.
General Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.