What’s the biggest mistake investors are making in today’s markets?
Interest rates are currently the lowest they’ve been in hundreds of years. In the early 1980s, people could get 13% interest on a bank account, but now “high interest” accounts pay less than half a percent.
You might say that it’s wrong for savers to suffer because the Central Bank has cut interest rates to zero to support the economy. I’d agree, but the fact is that ultra-low interest rates have forced many otherwise cautious people into taking “a little more risk” to earn a decent return on their investments.
When people believe that they need to take “a little more risk” to generate greater returns, they may be making a very BIG mistake if they underestimate what “risk” really means to them.
I’ve been trading financial markets for 50 years. I recently retired from the commodity and stock brokerage business after 44 years, and these days I actively trade my own money in the futures markets. The most important thing I do every day is to identify and manage risk. To me, that’s far more important than picking what to buy or sell.
Bullish investor psychology has driven markets higher.
During my brokerage career, I learned a lot about investor psychology. I learned that when people take “a little risk” and get rewarded, then the next thing they do is take “a little more risk.” First thing you know, they have become part of the “crowd” that has pushed the prices of many stocks and other assets far beyond any reasonable valuation.
People in the “crowd” don’t appreciate the risks they are taking because they’re surrounded by people who believe the market will keep going up.
So, what is the “risk” in markets these days?
I’m a futures market speculator, but I read all kinds of books about all kinds of markets. One of my all-time favorite books is The Most Important Thing by Howard Marks. Howard is a veteran market operator, he manages a $100 billion fund, and he also writes very thoughtful memos from time to time that you can read on his website at www.OaktreeCapital.com. I highly recommend Howard to you because he is a classic “Value” investor, and he clearly explains why he sees very little value in today’s overpriced markets.
One way to measure “risk” in today’s markets is to think of it as the difference between current market prices and the price where “value investors” like Howard would start buying. Believe me; the difference is HUGE.
Take A Look
Take a long hard look at what has happened to the S+P 500 market index over the past 40 years. It has had a spectacular rally. If you really want to get nervous, then study the Apple chart.
The amazing stock market rally of the last 40 years has occurred while falling interest rates have forced more and more people to shift from being savers to being “investors.”
The fact that many stocks have gone parabolic is a testament to how aggressively buyers have embraced risk. I think it would be fair to say that many of their market decisions have been more emotional than tactical.
My point is not that I expect the stock market to fall in half (which would take AAPL all the way back to where it was 6 months ago!) My point is that many people are underestimating their risk of loss in the stock market these days.
It’s not just the stock market. Virtually all asset prices have gone up as interest rates have tumbled. When there is no “hurdle rate” to the cost of money, then a lot of money gets “invested” poorly. There are very few bargain-priced assets these days.
Could the stock market keep going up?
Yes. The stock market could double from here. I think we’re in a bubble, and if we are, then “valuations” don’t much matter. The only thing that matters is “confidence,” and if people are confident that the market will keep going higher, it will probably. If people lose confidence for any reason, then the market will tumble.
When a market keeps trending higher, and higher bullish psychology becomes so deeply ingrained (Buy Any Dip), it creates the trend. The popular belief at market tops is that the trend is your friend.
In a bull market, the Fear Of Missing Out (FOMO) is so strong that people see marketing schemes such as “passive investing” as brilliant ideas. They willingly sign up to have money clipped off their paycheck and invested in the stock market every month, regardless of price. They do this because they have chosen to believe (or have been sold on the idea) that stock prices will only go higher.
Maybe they will. Maybe they won’t. I’m not saying bailout while there’s still time. I’m not saying put everything you have in gold or bonds or whatever. I’m just saying there’s been a lot of irrational exuberance the past few years, and asset prices have been bid aggressively higher. That means there is a greater risk of loss from these levels.
What should you do?
Work with your investment advisor to assess your portfolio risks and your risk tolerance. Decide if now is the time to make some portfolio changes. If not, then make plans to reduce risk systematically if the market starts to fall. That way, you won’t panic and make ‘spur of the moment” decisions if the market takes a tumble.
Like Sgt. Esterhaus from Hill Street Blues, back in the day when bank savings accounts paid a decent return, I’m just saying, “Be careful out there.”
Victor Adair is a veteran trader with 50-years of experience trading all types of markets. After retiring from “the business,” he set up a personal website to share his notes, ideas, and “the trading life.” You can subscribe to his website to receive his weekly newsletter. You can get his past notes on his website, “The Trading Desk.”