Remember these words when you invest and it will keep you sane a little while longer.
In a raging bull market, demand for “risky” investments goes through the roof. In a general bullish trend, perceptual risk is minimized, making people more apt to try “risky” investment vehicles. After awhile, people begin to believe that there’s no risk at all – they believe the bull can run on forever.
Judging a decision by the outcome is a killer in the stock market. In euphoric times, people can make the dumbest investment decisions and still make money. Does that mean it was a good decision? No! Likewise, people can make the right decision and still have a bad outcome. Investing is more of a probability game. You must make the decision that will make you money if applied consistently and persistently.
Suppose I opened a ski resort in Hawaii. As soon as I put my “open for business” ad in the papers, a blizzard hits the state and I’m instantly profitable. Did I make the right decision? Of course not; assuming the chances of a blizzard hitting Hawaii are astronomically slim, I just got lucky. That’s what happens to many investors in the short run. They get lucky, but as time goes on, the law of large numbers will expose their probabilities of success.
Firms have been wise to this process for years, but when clients rush to the phones/computers to sell, sell, sell out of panic, there’s not much a brokerage firm can do. Ah, the folly of human psychology. Too many judge their decisions (and the decisions of their brokers) based on outcome. They don’t see that every 55 times out of 100 the technique will work. They just see the one time it didn’t work.
It’s important to understand the concept of risk in investing, so you can avoid unnecessary risk.
Tools such as the Sharpe ratio help investors understand their risk/reward ratio.
Sharpe ratio = (expected return – risk free return*)/portfolio standard deviation
*Where a risk free rate, as an example, is a 10-year treasury bond
The Sharpe ratio is designed to allow an investor to analyze how much greater a return he/she is obtaining in relation to the level of additional risk taken to generate that return. While the word “risk” has different meanings to different people, it is a fool’s game to bet the farm on something that will fail 50% of the time, yet only offers a 10% return. Any Sharpe ratio above 1 is considered good, and above 3 is excellent.
However, no investment is without risk. Whether it is inflation risk, market risk, or default risk, it is ever present. It’s just up to you to be conscious of it… and not judge your decisions by your outcomes. Develop a winning strategy and stick with it.