Challenge Your Preconceptions, Or They Will Challenge You

Dear Clients and Friends,

Most believe that traffic lights make for safer traffic conditions and fewer wrecks, so in the mid 90’s, a group of researchers conducted an experiment where they would disable the traffic lights in the small town and monitor the traffic accident results. Researchers hypothesized that the town would experience an increase in the number of accidents. This was not the case. From 1994 through 2002, the number of accidents in the town went down 8% per year; in 2005, the town experienced just 1 traffic accident, an astounding result to say the least.* Now the point of this story is not to ‘pound the table’ on the abolition of all traffic lights and stop signs, but rather to illustrate the strange relationship we humans have with the perceived danger, risk, and safety. Traffic may be safer when people are aware of the potential hazards, just as investing may be less risky when participants are fully aware of the dangers.

The risk in many activities does not reside in the activity, but rather it lays in the participants actions in response to known and unknown risks. Warren Buffett once quipped that, “Speculation is most dangerous when it looks easiest”. There is no better example of this than in our collective markets. Just one year ago the participants in the market were euphoric about the future, but today they are downright pessimistic. For all Star Trek fans, the ultra-rational Vulcans would be stunned by the shift in sentiment seen over the last 12 months. The Federal Reserve essentially told us they were going to tighten financial conditions, and then when they decided to do so, the market was shocked. It responded to this ‘eyes-wide-open blindside’- sending stocks to their lowest point in years. To Investors who pay attention to human behavior, this should seem normalHumans have a difficult time discerning risk when conditions are near-perfect.

Then when things change, we act surprised that permanence gave way to cyclicality, but the history of our markets is based upon cycles rather than stasis. When market participants believe that there is no risk, they turn a risky game into an ultra-risky game; thereby amplifying the risk inherent in the activity. In other words, when participants believe there is no risk, they do things that would be unthinkable (compared to those who understood the risks). The riskiness of our investments in the midst of good times is almost meaningless, most assets do well in good times. But during bad times, low-quality assets perform poorly and the unseen risks materialize with losses. We are currently going through one of those bad times, with many tech stocks current 50 -70% losses this year alone. Cryptocurrencies have either lost all or most of their value. Most of the participants in these markets did not understand the dangers, and their behavior only compounded the risk. We have to be measured at all times; euphoric ideas of grandeur will always need to be juxtaposed against the risks. By that same ‘token’, feelings of pain and fear of loss need to always be checked by the reality of the market’s recuperative powers.

*Shared space, where the streets have no rules | CNN

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