How investors misjudge risk

Most people equate risk with either extreme volatility or with low quality assets. Retail investors are often told to avoid ‘risky’ investments to protect their money; to never even consider them (I can already feel the eyes of my readers narrowing in suspicion here, but bear with me!).

By contrast, ‘high quality’ investments are often referred to as those with desirable qualities such as those supplying low supply and high demand goods and services, or producing strong and stable cash flows. In the world of equities, these can often be in leading companies such as Microsoft or Apple (see the historic saying “no investment manager got fired for investing in IBM”). These ‘high quality’ investments are often considered safer and less risky – that is, less likely (if not impossible) to ‘hurt you’ in the long run (ever heard the saying “property always goes up”?)

This is actually a bit of a fallacy; you can get hurt doing pretty much anything – it’s more of a ‘degree of risk’ situation, where you’re more likely to get hurt by things you don’t see or understand than by things you do. There’s no actual reason why property must always rise; it can conceivably fall in value (or be impossible to value if you’re unable to find a willing and able buyer).

Consider the recent Wirecard scandal. $2bn in cash was suddenly declared ‘missing’ from a leading global payment processor and financial services company and likely never existed in the first place. This company was considered a rock solid investment by many thanks to the perceived security of audits from a leading firm, a listing on an established stock exchange in a liberal western democracy (Germany), and the company being ‘an established brand’. Despite this, the company filed for insolvency not long after declaring the funds missing…how ‘risk free’ was that investment?

Regardless, some investors are willing to invest in what they term ‘high quality’ assets at almost any price – and to deride anyone that looks for value or opportunity elsewhere. Personally, I believe that this can be a mistake.

If I walked up to you and offered you a house – a physical home, maybe with a bit of work that needed doing to it and maybe not in the best bit of town – and you trusted me, there’s a question you’d ask me. “What’s the price?”.

Now, if we go back to our idea that some investors consider some assets are not worth anything, what we’re saying is that those investors would not take that property at any price at all. I could offer it for a pound, and they’d still say “No, it’s a bad, low quality investment. It’s in a lousy area. The roof needs refixing. It’s not the best property in the city so I’m not interested.”

I hope you can agree that this would not necessarily be the best decision. Presuming I was honest about the issues with the property, and that it was actually mine to sell, you could arrange to have the property repaired and sell it on at a profit – providing the price was low enough. It’s not the swankiest house in town, but there’s still money to be made on it.

The Rising Price Fallacy

The other mistake that people make when it comes to risk is that when an asset is rising in price, most people are inclined to think it is a better investment and therefore less risky. Again, this isn’t really correct – if I but £10,000 worth of shares in a company and they double in value, my risk has actually increased in terms of my potential losses; where I could only lose £10,000 I can now lose £20,000.

Because the price is rising, they believe that the other people see the value and because other people see it then it must be there. They don’t consider what will happen when they come to sell the asset or who is providing the valuation information. Or, in the case of bonds, they rely too heavily on the ratings agencies (see my previous article about the dangers of investing in bonds).

To come back to my earlier point, risk exists where people believe that something is certain to happen; nothing in life is certain. I get really nervous when people start pitching me an investment as a ‘sure thing’ regardless of whether it’s property, equities, metals or some other kind of asset. The phrase ‘it’s got to happen’ is so dangerous precisely for the reason that in reality, pretty much nothing has got to do anything. You might perceive it to be more likely, but that’s all – your perception – and if there’s one thing I’ve learned, it’s that our perceptions of a situation are usually missing a significant chunk of context, nuance, and history.

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