The Edmond Sun

Business

November 15, 2013

THE ASTUTE INVESTOR: Risk and reward in uncertain times

EDMOND — He was dealt four great cards. The jackpot depended on the next card. But before it was dealt, a shot rang out in Nuttal & Mann’s Saloon in 1876, and Wild Bill Hickok hit the floor dead from a gunshot to the back of the head. His four cards — aces and eights — were forever immortalized as the Dead Man’s Hand. It became the symbol of gambles gone wrong, where hidden risks outweigh the rewards.

Risk is a funny thing. Everybody loves it when it works out, but it can be quite painful when it doesn’t. I learned a lot about risk from a cat named Vern. Vern was a cat I had years ago; or I should say that Vern had me. He wasn’t anything special; just an ordinary gray barn cat. But he was special to me and made me smile and laugh a lot.

Vern was a house cat meant to live his life protected indoors. The problem was Vern didn’t seem to know that and never missed an opportunity to be out hunting for whatever it was that he liked to hunt. Unfortunately, in the real world the hunter can sometimes become the hunted.

As long as Vern hunted during the day, the risks were fairly small. He almost always managed to come home about dinner time carrying his trophy from the hunt, much to the dismay of my horrified daughters. But night time was a different matter. The big hunters came out at night and the risks got a lot higher and the odds changed against him. As hard as I tried to prevent it, Vern often managed to find the right moment to bolt out the door and he was off for the night. He always came home; although more than a few times he looked like he got the worst end of a fight.

I never understood why he would never abandon the thrill of the hunt in exchange for the comfort of watching TV and eating snacks with me in the easy chair, but that’s just the way he was. The good news is that Vern was lucky and lived a long and happy life.

This is not a story about Vern. This is a story about risk. More specifically, it’s about asymmetrical risk; when the risk in one direction is far greater than the other. This is the risk/reward equation people talk about but rarely consider.

Asymmetrical risk has nothing to do with the odds of a given risk, but everything to do with the consequences of a given risk. In Vern’s case, the odds that a coyote would kill him were relatively low and the odds were hugely in his favor. For example, let’s say the odds were 50-to-1 in his favor. But the consequences of that risk were incredibly asymmetrical. In our hypothetical 50-to-1 risk, Vern returns home alive 50 times out of 51. But one time in 50, the coyotes kill him. By the numbers, that’s a good risk. In reality, that’s a horrible risk. No investor would take a bet like that — at least not knowingly.

As investors, we can’t afford to turn a blind eye to risks, especially not to asymmetrical risks. We can’t afford to take risks that are likely to work, but are likely to wipe us out if they don’t work. Understanding your potential reward is worthwhile. Understanding your potential risk is everything.

So here we are with markets at all-time highs. What’s not to love? What could possibly go wrong? Well, the bears say plenty. Are we on the verge of a melt up (new highs) or a melt down? The bulls say stocks are reasonably valued right now so there’s little chance of a crash in 2014 to 2015. Really?!

First, even on normal valuations measured by price-to-earnings (P/E) ratios, stocks are as highly valued as they were before the last crash in late 2007. In fact, 2013 looks almost exactly like 2007 did. Back then, GDP and job growth were good, but not great. Stocks had seen a bull market for about five years, and nine out of 10 such markets don’t last longer than that.

The so-called experts say there were no real negative signs in the economy. But think about that for a moment. There are never bad signs in the economy near a top. How could there be? That’s when the economy looks its best.

How did Japan look in late 1989 before a two-decade downturn into early 2009? How did the U.S. economy look in late 1929 just before the greatest stock market crash in its history?  How did the U.S. economy look in early 2000 before the tech wreck? And how did the economy look in late 2007 before the last great recession?

You can’t look at the economy for meaningful signs of an economic slowdown or a stock market crash. You have to look at demographics that foreshadow major changes years and decades in advance. You have to look at the smart money, the insiders who see changes before the public and the media do. And you have to look at valuations on stocks and real estate that suggest a bubble or long-term peak is about to burst. As the old stock exchange saying goes, “They don’t ring a bell at the top.”

I’m not suggesting the market is about to crash. I have no idea when that is coming. In fact, I think the market likely trends up well into spring of 2014. However, I do know that no market goes up forever and this bull market is getting long in the tooth. Risks are building. Be careful. My pal Vern beat the odds. You may not be so lucky. Thanks for reading.

NICK MASSEY is a financial adviser and president of Householder Group Financial Advisors in Edmond. Massey can be reached at www.nickmassey.com. Securities offered through Securities Service Network Inc., member FINRA/SIPC.

 

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