Risk Is Counterintuitive

The following is an adapted excerpt from our latest quarterly newsletter...

Fear of the unknown is an instinct that helps us survive, but acts against our better judgment as investors. It pushes us toward the perception of safety.

The U.S. stock market has steadily risen since 2009. It has not had a 10% correction (dropped 10% from a previous peak) since late 2011. The pattern of regular gains offers investors the perception that the market is predictable and therefore safe.

Humans seek patterns. Imagine an experiment in which a green light flashed 80% of the time and a red light flashed 20%, but the exact sequencing of the flashes was random. A pigeon or dog would learn to pick green every time. Humans, however, would try to guess whether green or red flashed next, even when we understood the flashes were totally random. We don’t like accepting how random the world really is.  

Yet, risk is counterintuitive. Fear that the market is risky actually makes it safe. Risk aversion causes investors to be more cautious, which keeps prices low. Conversely, when investors believe the environment is safe, they buy more aggressively, increasing prices and the likelihood of declines.

The result is that investors follow the herd, acting against their self-interest. They buy high and sell low. From 1994 through 2013, studies show the average U.S. investor earned 3.7% annually while the S&P 500 returned 11.1% annually. The average investor who started with $1 million would have ended with a balance of just over $2 million instead of $8 million that an 11.1% annualized return would have produced. 

Naturally, it’s better to invest when everyone is scared, no one wants to buy, and prices are low. But doing so means acting against our instincts because these are the periods when the world appears the most uncertain.

In sum, a smart investor will hit the brakes when the light is green and speed up when the light is red. It's a smart strategy that, as you can visualize, is very scary in practice.