How We SEE Risks

People tend to ignore risks until it hits them in the face. In investing, we fall in love with a stock that has gone up and don’t see the risks that could be underlying. Even worse, we screen for recent good performers and buy “hot” stocks. Then we wonder why buying high doesn’t always work out.

It happens on a large scale, like in 1999 when the party for high-flying stocks kept going. The fear of missing out pushed stock prices well beyond reasonable levels. The valuations kept pushing and pushing then - pop. Market gurus suddenly came out of the woodwork and said “I told you so”.

The housing crisis followed the same pattern. Money started flowing into housing and many people owned more than one home. The fear of missing out kept the momentum going. Home prices kept pushing and pushing then - pop. Again, market gurus came out of the same woodwork and said, “I told you so”.

These risks weren’t apparent until after the pop. Yeah, I know there were some voices that said this was unsustainable but I’m talking about the broad wave of speculative behavior. In the moment, most people ignored the risks because it’s something they can’t see. Gains are easily measurable; volatility and underlying risks are not.

The fallacy here being “I made money so therefore there was no risk” and “I lost money; I now see the risks taken”.

It’s more common than you might think. In 2020, there was an explosion of day trading and the amount of speculative stocks suddenly “winning” made the strategy appealing to the uninitiated. There was immediate success and Robinhood traders felt invincible. Risk didn’t exist in 2020 after the Covid drop.

I don’t know if investing should be exciting. Admittedly, I was swept up in 1999 and the investing bug never went away for me. The excitement initially pulled me in, but experience has taught me that boring is the most sustainable way to go. Though boring investing still is not risk-free.

Risk tends to rear its ugly head when we become complacent. Measuring complacency is not perfect but the Volatility Index (VIX) is a good starting point. The VIX has been called the fear index because it’s a gauge of how much volatility investors expect over the next 30 days.

In early 2020, the VIX hovered around 13 prior to the lockdowns. That March, the VIX spiked to 82 and the S&P500 dropped 35%. This isn’t a market timing tool because the VIX spiked simultaneously with the S&P500 drop.

A general rule for the VIX is a reading below 20 is considered low. Readings above 30 indicates heightened uncertainty and fear. The VIX is 12.2 as of May 21st.

The VIX is just one indicator in CNN’s Fear & Greed Index. I use this to get a sense of where the market might be. This isn’t a market timing tool because sentiment changes on a dime and the indicators typically swing to “Fear” after a sell off. Right now, it’s registering as “greed” after the S&P500 has already rebounded from April lows.

Risk is always lurking. Since we don’t see it, we tend to ignore it.

Notice the gauge read “Fear” in April, which in hindsight was a good time to buy. The S&P500 rebounded over 8% since the April lows. We easily could have been in the doldrums if inflation came in higher than expected or corporate earnings faltered.

The longer this indicator is stuck in “greed” or “extreme greed”, the more complacency that is baked in. Considerations for risks start to fade and the fear of missing out takes over. While it isn’t a signal to sell, it should raise awareness that certain assets have gotten richly valued and might need to be rebalanced.

Risks are worse in a post complacent environment because markets are falling from a higher perch. When the gauge swings to “fear”, risks are pricing back into markets. There’s always some narrative that attempts to explain the drop. “Extreme Fear” readings coincided with Covid lockdowns, the housing crash, and high inflation.

Risk is an inevitable part of investing. By learning to identify and manage risk, you can make informed investment decisions and achieve your financial goals over the long term. Remember, the most sustainable path to wealth creation is often the least exciting one: consistent diversification and a focus on the long game.

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