Complacency: The Biggest Investment Risk

Alex Green - Thu 15 Feb, 2007

No... The biggest risk right now, in my opinion, is complacency. Over the last few years, financial markets have risen so far - and with so little volatility - that the general perception seems to be, "Come on in, the water's fine!" This is not the way financial markets generally work.

I spend a lot of time talking about investment opportunity. Today I want to talk about its twin
brother: investment risk.

The biggest risk I see this year isn't the potential for a housing crash, higher energy prices, rising interest rates, a faltering economy or even another
major terrorist attack, although any of these       
are possible.

No... The biggest risk right now, in my opinion,     
is complacency.

Over the last few years, financial markets have risen so far - and with so little volatility - that the general perception seems to be, "Come on in, the water's fine!"

This is not the way financial markets generally work.
Ordinarily, equity investors enjoy superior long-term returns only because they regularly endure stomach- churning drops - and the sleepless nights that accompany them - along the way. Lately, however,
investors have enjoyed all the gains with none of   
the pains.
 
The Dow Jones Industrial Average, for instance, has gone 922 trading days without a 2% daily decline.
That's the longest stretch in history.
The combination of low rates, high returns and minimal volatility are creating the impression in the minds of many investors that maybe riskier investments aren't so risky after all.

Big mistake.

Money flows show that right now, investors favour growth stocks over value stocks, small-caps over large caps, foreign markets over domestic markets, and emerging markets over developed markets. They're also plunking for corporate bonds over government bonds, and junk bonds over investment-grade bonds.

Add in record volume in options and futures trading, highly leveraged speculation in the real estate market, and the ardent desire for Mom and Pop to plunk a portion of their retirement money in someone's
(anyone's) hedge fund, and you have the potential for some very unpleasant surprises.

I don't want to sound like Gloomy Gus. With rates low, the economy humming, corporate earnings strong and oil below $60; there are plenty of reasons for optimism.
 
But a lot of folks who are taking big risks may not understand the potential downside and - in many cases - aren't being compensated adequately. The spread between high-yield bonds and Treasury securities, for instance, has narrowed to 3.25% from a historic average of 5%.
Likewise, the gap between bond yields in emerging markets and U.S. markets has decreased to 1.75%, down from 4% just seven years ago.

What's the solution here? I'd start with a gut check.

If we had a major market break, how would you feel?
* Would you wish you had less exposure to stocks?
In that case, asset-allocate your portfolio now to spread your risk.

* Would you wish you used trailing stops to protect
your principal and your profits? Then, by all means, enter them now... and keep adjusting them as your stocks rise.

* Would you wish you had less money in futures or
options (which have little chance of surviving a major correction)? If so, lock in some profits now to reduce your overall risk.

It pays to heed the words of legendary fund manager Peter Lynch: "If you're going to panic, do it early."
Because - trust me on this - by the time it's splashed all over the front page of the paper, the horse will already be out of the barn.

Don't get me wrong... There's no avoiding risk. But you can manage it intelligently.

Don't let the complacency that is affecting so many investors creep into your own investment outlook. Take a look at your overall investment posture, and recognize that the market never tires of throwing us the occasional curveball.

Regards
Alex Green
for The Daily Reckoning

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