BOO! – Not As Scary This Year

Friday, October 30, 2009

Pumpkin treeLast October, stock markets had plummeted, bond markets were in disarray, banks were teetering and the news was terrible. It was truly a scary time.

We are removed from that period, but still have fresh memories. So, now is a good time to discuss RISK and how we should view it today.

Investing is necessarily a risky activity, with “risk” being defined as a chance of loss. Over the past two years, we have seen just about every risk come true. The silver lining is that we have gained valuable experience. Here are some lessons to recall as we move ahead.

It is easier to frighten people than to reassure them. This means we need to be careful not to get carried away when bad news comes out and pundits forecast worse to come. Whenever risk is exposed, we are especially susceptible. That is the time to work at regaining our objectivity and confidence. One important area, something I will address many times in my writings, is dismissing overblown media reports and overwrought commentators.

Most risks do not occur. Risks are unlikely events, so they usually don’t occur. The fact that they don’t happen, however, doesn’t mean that the risks don’t exist. And just because an investment has had no hiccup, or has produced dazzling returns, doesn’t mean it is immune to a blowup.

Risk occurrence cannot be foreseen. Particularly following bad times, there is a feeling that risks are destined to happen – a sense of fatalism. Risk occurrence does not mean certainty. It’s simply an example of a low probability event actually happening – like having your car tire go flat.

Risks are not controlled by insiders. A natural reaction to an adverse event is to look for someone to blame. In finance and investing, there are always people trying to take a shortcut to wealth and, when caught, can seem to be the source of the problem. However, except in their small, personal worlds, even the big frauds, like Madoff, don’t control the risks. In fact, they, more than anyone, want risks to remain at bay.

Risks are rarely dealt with in advance by governments. Another common reaction to something bad is that someone (usually the government) should have done something to prevent it. The problem is that governments are not prescient, so they, like we, must react.

Lastly, I want to conclude with what I think is the most important lesson:

Risks are not always clearly labeled. Wall Street is exceptionally good at creating investment products that appear to offer great returns for little or no risk. Their designs are always well timed to match investors’ current desires. Inevitably there is a combination of overstated benefits and understated risks, usually “proved” by looking at would have happened in the period just past (which created those investor desires).

To prevent personal loss from these apparently perfect creations, we must follow Missouri’s unofficial slogan, “Show me.” (The popular attribution is to a Missouri congressman’s 1899 speech in which he said, “…frothy eloquence neither convinces nor satisfies me. I’m from Missouri, and you have got to show me.”) A Midwest farmer’s common sense is a powerful antidote to Wall Street’s cleverness.

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