An Important Aspect about Risk-Taking in Investing That Investors Must Be Aware

The past few years have been a good time for investors and businesses.

For investors, risk-taking has been richly rewarded, with the stock market putting on some strong gains, as evidenced by the 125% increase in the SPDR STI ETF (SGX: ES3) since its financial-crisis lows; the SPDR STI ETF is a proxy for Singapore’s market benchmark, the Straits Times Index (SGX: ^STI). In the U.S., the S&P 500 has done even better, gaining 202% from its trough during the crisis.

As for businesses, they too have found it easy to ratchet on the risk and take on ever-increasing amounts of debt to fuel growth given that interest rates have remained low.

But it’s in heady times like these when it’s important to retain a focus on risk. Why? Because of a phenomenon financial advisor and behavioural investing expert Carl Richards calls “risk creep.” In a recent article Richards penned for the New York Times, he described it as such (emphasis mine):

“It’s fascinating how often we look back on mistakes and see all the obvious warning signs. They’re so obvious we openly admit how dumb we were to miss them. The cause seems to be associated with something I’ll call risk creep.

We start with a plan that offers a clear margin of safety. Then, slowly, we allow ourselves to take just a bit more risk. Of course, we don’t call it that. Most of the time we don’t even recognize we’re doing it. As things go well, our perception of risk goes down. We start to feel safe and as a result we take one small step into territory that we previously labeled out of bounds.

The process repeats. Take a small risk. Things go well. Increase risk. Repeat until failure.

With companies, risk creep can manifest itself in the form of growing leverage. And over the past two years, there’ve been more than a handful of locally-listed companies that have piled on the borrowings with each passing year.

The trio of Maxi-Cash Financial Services Corp Ltd (SGX: 5UF), Aspial Corporation (SGX: A30), and Neptune Orient Lines Ltd (SGX: N03) are just three of a larger group of 89 companies in Singapore that have increased their net-borrowings (total borrowings minus total cash) as well as their net-debt to equity ratios in the two consecutive years between January 2013 and today.

Net debt to equity ratios for Maxi-Cash, Aspial, and Neptune Orient Lines

Source: S&P Capital IQ

Richards’ reminder about risk creep came amidst a recent warning from Piyush Gupta, chief executive of Southeast Asia’s largest bank, DBS Group Holdings Ltd (SGX: D05), that the credit cycle in Asia is turning – in other words, cheap debt might just become more expensive in the near future.

Companies which are already heavily-leveraged and yet have steadily increased their exposure to financial risks through the use of even more leverage – such as the trio of Maxi-Cash, Aspial, and Neptune Orient Lines with their triple-digit net-debt to equity ratios – would likely be the most vulnerable if the credit cycle does turn.

None of the above is meant to say that the aforementioned trio would necessarily make for bad investments going forward. But as we’ve been living in some good times over the past few years, it would pay for us investors to keep an eye on the risk creep phenomenon, be it in the form of our own investing activities, or the actions undertaken by the companies we own.

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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.