What's So Bad About Risk?

by: James Picerno

Last week's stock market swoon is a reminder that there's no shortage of worries to distract investors. For some pundits, the rising anxiety appears excessive. The economy still looks healthy in general. Over the weekend, one widely-read columnist noted that consumers are still lining up to buy various luxury goods in his hometown. As a result, the odds of anything more than a mild slowdown look remote, he reasoned.

Yes, the risk of expecting the apocalypse is almost always a poor bet. The world always seems to muddle through even the worst disasters. War, terrorism, high inflation, misguided government policy, and so on, are events that are always hanging over the economy. Meanwhile, the ebb and flow of capitalism has been known to push markets to excess. Yet, life goes on, and patience usually pays off in the long run. Such are the virtues of looking past the headlines of the moment, and on to the opportunities of the future.

We couldn't agree more. Strategic-minded investors should maintain perspective, and keep emotions in check. But that includes recognizing that a perennially sunny disposition harbors risk too. That includes the recognition that even if the long term works out, which it usually does, the short term can try investors' souls and push the best-laid plans of mice and men to do unproductive, and even self-destructive things.

It's easy to proclaim allegiance to the long term when markets are rising, as they've been doing for the better part of the past five years - at least until last week. But how many of those who champion strategic virtue will hold true to the vision when the hour is darkest?

Such is the challenge of emotion, which is perhaps the greatest enemy of investment success. The human brain is a wonder, but when it comes to making decisions about money it's not necessarily hard-wired for success, as a fascinating new book from Jason Zweig details (Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich).

But we have digressed, so let's get back to the economy. Yes, it's looking good, more or less, although the rosy overview stems from looking backward. It's worth reminding that economic growth always looks like it's going to continue, right up until the point when the good times stop.

Yes, warning signs usually precede such moments of upheaval and reversal. The problem is that there are always warning signs. Separating the false warning signs from the relevant ones is what keeps economists in businesses, and most investors humbled over time.

Even the greatest of economic booms aren't perfect: Something is always misfiring, suffering, or always looks like it may fester into something worse. For the most part, the imperfections are consumed by the expansionary winds. In short, it pays to be bullish most of the time.

So it goes. Risk is always and forever present, in the markets and in our decisions, and it's constantly provoking us to do the wrong thing. Fortunately, most of the risk that inhabits the capital markets, and the global economy can be offset by taking a long-term bullish view. Yet even this disciplined minority should sleep with one eye open. As Nassim Nicholas Taleb has written, the deficiency of evidence for a particular outcome shouldn't be confused with a guarantee of how the world works.

Yet for those with the discipline to remain truly focused on opportunities for the next five, 10 or 20 years, the world may very well end up being a kinder, gentler place. For everyone else, the investment horizon unfolds one day at a time. That's a self-defeating view, and it's one that can and should be muted by any and all means necessary. But it can never be fully banished, which is probably why many studies show that investors generally receive a good deal less of the performance than the markets dispense over time.

Perhaps that's one reason why the financial gods invented diversification, and the utilitarian pleasures of cash. Indeed, the only thing better than being a disciplined long-term bull is being a disciplined long-term bull with the capacity to buy when blood runs in the street.