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When the Walls Come Down

Investors chase market returns. Anyone who has looked at the data sees this phenomenon play out over time and across asset classes. As a market declines, investors pull their money out. As that market rises, investors put their money back in. On the whole, investors earn less than they would have had they simply stayed put. Carl Richards coins this phenomenon the “behavior gap.”

 By one estimate, investors lose up to 1% per annum by poorly timing their buys and sells.

Research indicates that investors aren't necessarily trying to time the market; rather they are extrapolating returns several years into the future.

 A likely explanation for this is that risk-averse investors need to see some confirmation that it is “safe” to invest in a particular asset. The only visible sign to most investors that a market is safe is that the price has gone up. The opposite case holds when prices decline.

This goes back to our differing explanations of risk. To the investor who is solely extrapolating returns, the market that has fallen in price seems more risky because all you see is further losses down the road. However, to fundamental investors, an asset that has fallen in price, absent any additional bad news, has become cheaper and is therefore less risky. It will take at least the absence of bad news to bring investors back into the market.

In that sense, it is often said that markets climb a “wall of worry.” We can best think of a wall of worry as the market's list of real, potential, and imagined risks. A stock is always in the process of pricing in those risks. As time goes on and those risks are proved to be either unfounded or less impactful than previously thought, investors become more comfortable. More comfortable investors

 make for a higher stock price. The opposite is true as well: if risks not foreseen come to pass, a stock will decline as investors rate it as riskier than previously thought.

At any point, there is a cornucopia of potential risks. There are your run-of-the-mill economic concerns focused on growth and inflation. Any individual company or industry faces another whole set of specific risks focused on sales growth, disruptive technological innovation, and competition. Then there are your more existential risks like global warming or terrorism. It is not hard to come up with any number of risks with wildly varying probabilities of occurrence.

Indeed, some analysts make their living by focusing on a particular risk to the exclusion of all others. This risk might be hyperinflation, or it might be deflation; whatever it is, according to these analysts it is devastating, and it is often just around the corner. These analysts usually have some preferred asset that is assumed to be a shelter from the coming storm.

We find it ridiculous when the term guru, which has its origin in religion, is applied to investing. However, in the case of those analysts who are wedded to a single overarching worldview, the term is appropriately applied. The world of investing is too complicated a place to rely on so-called gurus whose advice withstands any factual refutation.

So most of the time and for most assets, there exists a wall of worry. It takes a lot to convince the general public to achieve a level of willful disbelief that the risk in any asset has been eliminated. For any market, or stock, to achieve this level of risk blindness, something else needs to occur. A market needs to eliminate the proverbial wall of worry before it can seem like it is bulletproof to investors. Ironically those markets that have performed the best, that have supplanted whatever worries existed and now seem invulnerable, are actually the riskiest. This perception of invulnerability sows the seeds of the market's eventual and inevitable decline.

One need only look back a few years to see how this played out in the great housing boom and bust of the early twenty-first century. A slow and steady rise in house prices eventually morphed into a full-on housing frenzy. It seemed to many that there was little or no risk that housing prices could ever fall on a sustained basis. In some cases, buyers were able to refinance in excess of the entire value of a

 home in the belief that price appreciation would make up the difference. One can trace the financial crisis that followed in part to the belief in ever-rising home prices.

The models that Wall Street used to price the many complicated securities that came out of this housing boom did not take into account the potential for a sustained, nationwide decline in home prices. However, here we sit with home prices at or near postpeak lows.

 The effects of the housing boom (and bust) are still reverberating through the banking system and global economy.

This example shows the real-world consequences of pushing the concept of risk to the back burner. Housing booms and busts don't come around all that often, but when they do, they can have systemic effects on the economy and the financial system. Booms and busts are a fixture in market history. The challenge is not to allow risk blindness to cloud your judgment about future possible returns.

The question for investors today is whether these periods of excessive optimism are becoming more frequent. One could argue, like Barry Ritholtz does, that we are experiencing a “bubble in bubbles.”

 Whether these bubbles are real or imagined, it matters for investors who have to live in their wake.

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