How do you look at risk in your investing decisions?

Thinking about the markets, I thought of a lecture I attended where legendary investor Howard Marks discussed how he looks at risk.  His insights in this regard are always relevant and especially noteworthy in today’s market.

The Risk of Holding an Asset

Marks’ first observation is that as the price of an asset rises, so does the risk of holding that asset. 

Absolute Price Levels and Risk

Essentially, the concept here is that if a stock is at $10 and something bad happens, you can lose $10.  If that same stock rallies to $30 and something bad happens, you can lose $30.  This may seem counterintuitive. 

The tendency is to think that a stock that went from $10 to $30 is a better company now than it was then.  That often is the case.  However, as simple as it sounds, “things happen”. 

• Competition comes in. 
• Products become obsolete.
• Lawsuits get filed. 

One can make a list. 

>> See What Determines Stock Prices?

Price-to-earnings Ratio and Risk

While absolute price levels can indicate a degree of risk, there is another metric that is often used.  The price-to-earnings ratio (P/E) of a stock indicates how much above and beyond the annual profits per share investors are willing to pay to own the shares. 

>> See Evaluating Price-to-Earnings (P/E) Ratios

If there are many positive expectations for future profits, investors will pay a “high” P/E.  If there is pessimism, the shares will trade at a “low P/E”.  The higher the P/E, the greater the enthusiasm and the greater the room for disappointment.  High P/E stocks are vulnerable to negative news and developments.

>> See Risk and Return When Investing in the Market

Investing Is Not About Complacency

Investors cannot be complacent.  Investors need to follow the news flow regarding their investments and not assume that just because a stock is up today, it will always go up.  As is said on The Street,

“You can’t fall in love with a stock.” 

Rebalance Your Investment Portfolio

In addition, investors should be prudent and rebalance their portfolios.  Too many eggs in one basket is not ideal.  Taking some money off the table in a winner is sound thinking. 

It helps if investors have a plan and an allocation that suits their needs and goals, and manage their portfolios to their planned allocations.

When you look at today’s stock market, you see pockets of the market where prices have gone up considerably during this bull market.  Magnificent 7 stocks, AI stocks, and quantum computing stocks are some of the areas where prices and P/E multiples have gone up with a significant amount of investor enthusiasm.  As an example, the Magnificent 7 stocks now make up about 34% of the market cap of the S&P500.  This is up from 27% in 2020.

Markets Swing From Extreme Pessimism to Extreme Optimism

Howard Marks continued his comments on risk by zooming out from individual securities to markets in general. 

Markets swing from periods of extreme pessimism to periods of extreme optimism.  The move in sentiment happens gradually and appears as a repeating cycle. 

>> See Why Business Cycles Matter in Financial Planning

During a bull market, reluctance/worry to invest leads to optimism, which in turn builds to excitement in the market, and the market finally peaks when there is exuberance on the part of investors. 

Bear markets begin with this exuberance.  As the market begins to fall, still-giddy investors are in denial. They make excuses, and traders become “long-term investors,” and they are afraid to take losses.  Denial leads to fear and desperation.  Panic sets in as investors can no longer stand the pain and start selling.  As prices continue to fall, investors sell everything just to be out. 

At this point, there is despondency.  Investors believe that stocks will never go up.  Recall Businessweek’s 1979 cover declaring, “The Death of Equities”?

At this point, the system is cleared, and the stage is set for a new bull market to begin. Classically, investors at first do not believe in the newfound stock price increases.  Their apathy continues until they eventually fear missing out and reluctantly begin to buy. 

The cycle continues.

Fighting Emotional Responses to Market Cycles

Where we are in the cycle is hard to tell. 

The lesson is that this pattern exists and investors should fight the emotional responses that bind one’s actions to the cycle.  Different markets or parts of markets can be at different stages. 

• Are AI stocks near peak exuberance? 
• Are small caps which have had multiple years of under-performance somewhere near “despondency or depression”? 
• European stocks, which until the Trump Administration began its tariff policy were in the doldrums, began to rise this year.  Are European stocks in the “reluctance/worry” stage?

The framework suggested by Marks is partly contrarian and partly risk-management based. 

>> See Why Modern Value Investing and Being a Contrarian Go Hand in Hand

It’s useful to try to determine where, in terms of the cycle, an investment you are considering sits.  You want to be cautious if the stock is part of a group showing exuberance, and perhaps you want to be more interested in a stock that is in a group that is just beginning to attract interest.

Thanks for reading. Don’t hesitate to reach out with questions and observations.

Image credit: The Miriam and Ira D. Wallach Division of Art, Prints and Photographs: Print Collection, The New York Public Library. “Two sailors on the warship Matsushima risk death to protect the powder magazine.” The New York Public Library Digital Collections. 1894. https://digitalcollections.nypl.org/items/5a49e9b0-84c8-0133-fd93-00505686a51c

Visual courtesy of Stover Financial Planners

Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. Investing involves risk.