How do investors cycle between risk tolerance and risk aversion? When is the market at its riskiest?
Howard Marks contends that as a result of the fluctuations between greed and fear, most investors alternate between being overly risk-tolerant and overly risk-averse. Risk tolerance leads to inflated securities prices, eventually leading investors to become risk averse because of these excessive prices.
Discover how Marks explains risk tolerance vs. risk aversion, and how the former can cause the latter.
The Cycle Between Risk Tolerance and Risk Aversion
First, to explain risk tolerance vs. risk aversion, Marks writes that when investors become greedy—which occurs whenever the economy prospers, profits rise, and credit is accessible—they’re more willing to purchase stocks and other securities at a premium. For example, even if Apple’s share price is exceedingly high, greedy investors might reason that it’ll keep increasing, meaning they think the currently inflated share price is moot because they’ll earn a significant profit regardless.
(Shortform note: In The Warren Buffett Way, Robert G. Hagstrom explains that you can resist the temptation to buy overpriced stocks by calculating stocks’ intrinsic value and only buying stocks that are currently below this threshold. Intrinsic value, he clarifies, is roughly a company’s projected lifetime net income divided by its number of shares—this allows you to calculate the intrinsic value of each share. By calculating intrinsic value, you can determine whether greed has caused a stock to become overpriced by seeing whether its current share price exceeds its intrinsic value per share.)
The upshot is that when investors believe the securities market poses the least risk (that is, when they bid up prices), it actually carries the most risk because securities are overpriced. According to Marks, savvy investors will realize that the market is overpriced, leading them to begin selling securities and dropping their prices. As other fearful investors see these initial price drops, they’ll likewise sell securities, causing a cascading series of price drops.
Marks contends that over time, these decreases in price will cause investors to become risk averse—they’ll become convinced that prices can only drop further, making them reluctant to purchase securities that are actually a good bargain. Thus, when the securities market is least risky because it’s underpriced, investors tend to be most risk averse.
(Shortform note: Marks’s contention that the market is riskiest when investors believe it’s the least risky, and vice versa, jibes well with the approach known as contrarian investing. Contrarian investors seek out investing positions that run counter to current investing trends, reasoning that these trends often reveal opportunities. For example, a contrarian might reason that bearish markets are likely to feature underpriced securities, making a bear market ideal for purchasing more securities.)
