The Cycle In Attitudes Toward Risk

The rational investor is diligent, skeptical, and appropriately risk-averse at all times. But also on the lookout for opportunities for potential return that more than compensates for risk.

What is investing?

One way to think of it is as“bearing risk in pursuit of profit.” The ability to understand, assess, and deal with risk is the mark of the superior investor and an essential requirement for investment success. The way investors are collectively viewing risk, and behaving in regard to it, is of overwhelming importance in shaping the investment environment in which we find ourselves. The state of the environment is key in determining how we should behave with regard to risk at that point. Assessing where attitudes toward risk stand in their cycle is what this chapter is about. Risk aversion is the main element that keeps markets safe and sane. Attitudes toward risk change, and in doing so they alter the investment environment.

The next section of this chapter comes from the memo Risk and Return Today, October 27, 2004 which includes several graphs you may want to view.

Fluctuations in attitude towards risk can cause exceptions to the principles of risk and investing described here. Sometimes investors can become too risk-averse, other times they can become too risk-tolerant. The greatest source of investment risk is the belief that there is no risk. Widespread risk tolerance, or a high degree of investor comfort with risk, is the greatest harbinger of subsequent market declines. Risk tolerance is unlimited at the top of the market and nonexistent at the bottom. When other investors are panicked and depressed, and can’t imagine conditions under which risk would be worth taking, we should turn aggressive. Skepticism calls for pessimism when optimism is excessive, and it also calls for optimism when pessimism is excessive.