The great rise in the stock market during the last years of the 1990s led many investors to forget the inevitable link between risk and return. This is because they had the return first and had, until the Dotcom Bubble busted, yet to wake up to the risks. If history was anything to go by, and there was not an alternative guide available, it was likely that the market would fall sufficiently to affect people’s short-term attitude about the market. And that happened.
Those who emphasize high returns that come from holding stocks usually fail to draw equal attention to the risks. This is tantamount to ignoring one of the most fundamental ideas of economics, “there is no free lunch.” Markets do not give something for nothing. In the case of financial markets, higher returns always reflect higher risk.
During bull markets the principle that there is no “free lunch” is easily forgotten. Almost by definition, a bull market is a period in which investors get high returns with little, if any, apparent risk. This readily leads to the assumption that there never was any risk in the first place. The true conclusion is that investors get lucky, as even the briefest glance at a longer period of history will reveal.
Whatever uncertainty there may be about the reasons that the stock market goes down, the consequences of their doing so are clear. This is especially true if the market becomes a bubble. All the bubbles of the 20th century were followed by severe declines. The high levels of investment, the low levels of saving and high levels of debt, which have been caused by the bubble, are abruptly reversed. Falls in consumption and investment are symptoms of the decline. Just as the reverse were the symptoms of the advance.
The stock market decline after the Dotcom Bubble tested many so called “long-term investors.” While many investors of the time stated that a 15-30 percent fall in stocks would not shake them from the market, most were talking about the indexes. However, many high-tech and internet related stocks fell 50-80 percent. Some went out business. With such a narrow concentration of holdings, brought on by the rapid advance of select sectors of the market during the updraft, many individuals were down in their portfolios much more than their risk tolerance permitted by 2001.
The bottom line is that one must first define their attitude, objectives and risk posture in order to develop a good investment strategy because there is no such thing as risk free investing. It’s worth remembering the old saying on Wall Street, “Don’t confuse brains with a bull market.”
Quote of the Week: “We have to learn to be our own best friends because we fall too easily into the trap of being our worst enemies.” – Roderrick Thorp
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.