The Riskiest Time To Invest

When is it the riskiest for us to invest? As paradoxical as it may seem, it is the time when there is the overwhelming belief that there are no risks.

Howard Marks, the co-founder of asset management firm Oaktree Capital, is widely regarded as an astute market commentator. Billionaire investor, and the world’s fourth richest man, Warren Buffett, has been quoted as saying, “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something, and that goes double for his book [referring to the book The Most Important Thing].”

Given such high praise from none other than Buffett himself, and also Oaktree’s enviable track record  – the firm’s 17 distressed debt-funds had averaged 19% annualised returns net of fees for the past 22 years ending 2011 – Marks’ words are certainly worth noting.

In Marks’ book The Most Important Thing, he communicated his idea on how investing is at its riskiest just when everyone thinks there’s no risk present. This is something he wrote on the topic:

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.

And, of course, as demonstrated by the experience of Nifty-Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. No risk is feared, and thus no reward for risk bearing – no “risk premium” –is demanded or provided. That can make the thing that’s most esteemed the riskiest.”

Let’s go through the first excerpted-paragraph from Marks. We’ve seen it play out exactly the way he described when Greece’s stock market, as measured by its ASE Index, became the best performing stock market in the world (except for Venezuela’s) for the period ranging from 5 June 2012 to end Oct 2013, gaining 146% in that short 1.5 year period.

During that time, investors had viewed the country as extremely risky, and rightly so given its nightmarish GDP, which fell by 6.4% in 2012 and dropped by another 4% or so in 2013.

But because of the widespread belief that Greece was a really risky country to invest in, its stock market collapsed to the point where the Cyclically Adjusted Price Earnings Ratio (CAPE) of the ASE Index was at 2 back in June 2012. At such a low earnings multiple, it’s not hard to conclude that “all optimism has been driven out of its price”. Yet, it was precisely that low price that made it the least risky thing and helped set the stage for its subsequent blockbuster returns.

It was a broadly similar situation with Singapore back in 10 March 2009 when the Straits Times Index (SGX: ^STI) hit its low of 1,456 points during the Great Financial Crisis. At that price, it was selling for around 6 times its trailing earnings, again signalling a lack of any optimism in the future of corporate Singapore.

What happened next is no real mystery: the STI has gone on to more than double to its current level of around 3,300 points.

Now, let’s look at the second excerpted-paragraph from Marks’ book. For some context, the Nifty Fifty refers to a group of fifty American blue chip shares in the ‘60s and ‘70s. They were extremely well-regarded growth stocks and hence were sold at extremely high earnings multiples, reaching a frothy-average of 41.9 in 1972. The Nifty Fifty were eventually decimated during the 1973-1974 bear market in the USA.

In a more recent example, the software maker Microsoft embodied Marks’ idea that it is precisely when people believe that something carries no risk that prices get bidded up to risky levels.

The company was selling for 72 times earnings at the start of 2000 and despite tripling its earnings in 13 years from then till now, its shares have gone nowhere since.

While the idea may be contentious, I think we’ve also seen similar scenarios develop here in Singapore last year with shares like Blumont Group (SGX: A33) and Asiasons Capital (SGX: 5ET).

Both companies were part of a trio that included LionGold Corp (SGX: A78) that saw their share prices get slashed by more than 90% in three trading days from 4 – 8 October 2013. In particular, Blumont and Asiasons carried ludicrous earnings multiples of 500 or more shortly before their spectacular meltdowns.

At such valuations, it’s hard to see how buyers were not looking at them as a sure-fire way to riches before their collapse. And yet again, it was that ‘sure-fire’ mentality that saw their shares get bid up to the skies, to the point where risk became enormous.

Foolish Bottom Line

It’s inevitable that we face risks when we invest in the stock market. But, those risks can perhaps be mitigated if we’re more aware of the risk-taking-attitudes that others are displaying in the market.

When there’s a strong and overwhelming belief by others that no risk is present, hence emboldening them to invest in risky ways by pushing up prices in relation to value, that is when it’s the riskiest time to invest.

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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 contributor Chong Ser Jing doesn’t own shares in any companies mentioned.