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What You Really Need To Know about Risk When It Comes To Investing

The State of the Union address is an annual speech given by the President of the United States to other American policy and law makers. Each year, the speech contains the prevailing fears and concerns, or cheers and confidence, of the American public. Or as my American colleague Morgan Housel recently put it in a fascinating article titled “How Presidents Predict the Stock Market”:

“The president’s job is to pander to the mood of the day. His remarks [during the State of the Union Address] rarely contain balance, nuance, or qualification. They reflect, almost perfectly, what the average American is angry or excited about.”

This makes the State of the Union a great measure of sentiment about the American economy for any given year.

Now, Morgan’s article was fascinating for me for two reasons. Firstly, it went on to showcase how some of the US presidents’ speeches could have been used as a great contrarian predictor of future US stock market performance. Secondly, it highlighted what, in my opinion, is the most important thing when it comes to thinking about risk in investing: It’s the riskiest time to invest just when everyone thinks there’s no risk and conversely, it’s the safest time to invest just when everyone thinks risk is at its highest.

This segues into an idea first articulated by the economist Hyman Minsky decades ago: Stability is, paradoxically, the thing that causes instability. Morgan had touched on Minsky’s work previously in an article titled “Why Markets Will Always Crashand this is a short excerpt from it:

Whether it’s stocks not crashing or the economy going a long time without a recessions [sic], stability makes people feel safe. And when people feel safe, they take more risk, like going into debt or buying more stocks.”

In 2012 and 2013, Greece’s economy was in a horrendous state with its gross domestic product (GDP) shrinking by 6.4% and 3.7% respectively. Things looked really risky for investors and valuations were driven to absurd lows as a result, which made Greek stocks safe. For instance, in June 2012, the country’s market was being valued at a cyclically adjusted price earnings (CAPE) ratio of only 2. That high perception of risk subsequently helped drive Greece’s Athens Stock Exchange Index to gains of almost 150% between then and October 2013.

Our stock market in Singapore was also a recent benefactor of high perceptions of risk. When the Straits Times Index (SGX: ^STI) was at its trough of 1,457 points in March 2009 during the 2007-09 Global Financial Crisis, it was valued at only around 6 times trailing earnings. Today, it’s some 125% higher at its current level of around 3,277 points.

China’s stock market on the other hand, had a bitter taste of what it’s like for investors to ‘feel’ safe. The table below charts China’s growth in GDP between 2000 and 2008:

Year

Change in GDP

2000

8.4%

2001

8.3%

2002

9.1%

2003

10.0%
2004

10.1%

2005

11.3%

2006

12.7%

2007

14.2%

2008

9.6%

Source: World Bank

Those are phenomenal growth rates and I think it must have helped engender a feeling of ‘safety’ for investors in China’s companies. My guess is also supported by how China’s Shanghai Stock Exchange Composite Index (SHSEC index) was valued at almost 80 times its trailing normalised earnings (i.e. earnings that are adjusted for unusual corporate activities like merger and restructuring charges, or accounting changes etc.) at the start of 2008. But as it turns out, that ‘safe’ feeling was a mistake, with the SHSEC index having fallen by 61% since then.

The world of investing is full of paradoxes – the important idea that risk is at its highest just when the perception of risk is at its lowest is just one such example. Unfortunately, that’s just the nature of the beast. We have to get used to it.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.