Investment Success: Understanding the Difference Between “Real” and “Perceived” Risk

 In Strategy Updates

Given the small, short-term market decline on Friday we thought it would be a good time to share some thoughts about market volatility, risk and the overriding importance of growing your assets over the long run.

Over the past two decades, our Active Risk Management process has mitigated the risk of catastrophic decline in the whole market (2008), specific sectors (oil and materials in 2014-15) and in individual companies.  This process is in place to handle and manage “real” risk as opposed to “perceived” risk and thus far has proven to be invaluable.  Investment performance is about many things, but mitigating large losses is definitely one of them.  Achieving long-term investment performance with reduced volatility is our goal.  But what do we mean by “real” versus “perceived” risk?

Investing is a craft of the known and the unknown.  Our research and experience allows our team to gather all known facts about a company, sector or market.  However, there are always a significant amount of unknowns that we face such as the threat of war, the Federal Reserve’s next move or the results of the upcoming election.  It is the list of the unknowns that bring about risk.  Obviously, if all investors knew everything, there would be no risk and, as well, no possibility of return.

The mere idea of risk or the unknown is the necessary element that allows for investors to reap rewards, and has made the stock market the best performing asset class over time.  However, risk also plays with our human emotions.  Let’s face it – the human brain is just not good at investing. We can’t tell the difference between a “real” risk and a “perceived” risk.  When the Great Recession of 2008 was at its depth, it was perceived by most investors to be never-ending and people avoided the stock market.  That risk was never “real” and was simply a “perceived” risk.  The difference was costly to those that missed the big multi-year bull market that followed.

On Friday investors sold stock because they perceived that the Fed will raise interest rates.  However, that perception has proven incorrect many, many times since the 2008 crisis and those investors who have sold on that perception in the past have missed out on great stock opportunities.  Maybe this time is different and that risk will be “real.”  If so our Active Risk Management process will come to our aid as it has in similar situations.  In this case, higher rates will create great opportunities in certain parts of the markets, particularly in financial stocks.

The biggest problem with “perceived” risk is that it causes the human brain to run away, as opposed to stay pat or run towards.  For instance, time and time again we will see the stock price of one of our great companies fall in value over the short term based on some “perceived” risk – only to increase significantly once that perceived risk is proven incorrect.  This is the reason that all the great investors (Warren Buffet and John Templeton included) counsel investors to ignore short term movements in a stock, a sector or the whole market.  These words could never ring more true in today’s investment world.  Paying attention to a stock, a sector or a market that’s temporarily – and not significantly – down is a waste of one’s time at best, and at worst can be very hazardous to our ability to enhance wealth.  More often than not, when one of our great companies temporarily falls in value, it is an opportunity for greater performance in the future.  Similarly, those companies in your portfolio that have demonstrated great recent performance may be headed for a period of less than stellar short-term performance. In neither case should an investor consider selling or buying, but let time ring out the “perceived” risk so they can reap the long-term rewards.  What we call “short-termism” is hazardous to your wealth!

Lastly, we want to touch on “real” versus “perceived” risk.  There are very real risks in this world of investing.  Though we suggest that investors take a long term view, we do not subscribe to “buy and hold” nor do we have any interest in riding investments down into catastrophic losses. Therefore, we have measures and experience in detecting real risk.  For instance, for decades a normal bull market correction has been the equivalent of an 8-10% decline.  That’s right! A 10% decline in your stock market value is common during market corrections.  In a bull market, such as from 2009-15, we had around 18 of these pullbacks that ended up at much higher highs.  Trying to avoid these short-term insignificant pull backs is a loser’s game – and learning to live with them is a winner’s.  This should also be a reminder to those investors who consider that anything less than their portfolio’s most recent new high is a loss – this type of thinking is self-defeating and unsuited for building long-term growth. Markets move upward in a zigzag pattern and normal corrections along the way are as old as Shakespeare’s works.

However, when markets, sectors or individual stocks start declining by more than normal, investors should pay attention.  Typically declines beyond “normal” signify “real” risk and require attention.  Think 2008 when the market started falling by more than 10-12%, oil in 2014, or any number of individual stocks that begin such poor behavior.  These are the cases where our Active Risk Management process kicks in and mitigates the risk of catastrophic decline.

We hope you find this update of interest and that you think of “perceived” versus “real” risk over the coming days, weeks, months and years. It is easy to get caught up in short-term price fluctuations, recent news and “perceived” risk – but it can be detrimental to your peace of mind and to your long-term success. Lastly, keep in mind that when “real” risk presents itself, your team at MSR has the tools to handle it for you.

If you would like to discuss your portfolio or have recently experienced a significant change in your financial situation, please let us know. Thanks from all of us and enjoy your weekend!