A Tentative Start

On the heels of the strong finish to last year, stock market averages posted flattish to moderately positive results for the quarter. Beneath the surface of this relatively lackluster outcome are several observable shifts from recent trends.

We should not be surprised to see investors on high alert for the next bubble.  As with most things, all of us have a heightened sensitivity to recent events.  This explains why sales of flood insurance spike higher right after that so-called “100-year” flood, not after 99 years of drought.   It also reminds us of a client’s question around the market bottom last March, asking if this was a good time to buy annuities with a guaranteed return.  Our response was “No, but it is a good time to be an annuity salesperson.”

This piece is another in a series that takes a closer look at how investors typically make investment decisions.  In this case, we look at one of the key inputs in developing an investment strategy – risk tolerance.   An investor’s tolerance of risk is an individual and personal assessment.  Research  suggests, however, that few of us understand ourselves as well as we think, and our ability to project how we might react in certain situations is surprisingly inaccurate.

In the spirit of this column’s focus on broadening our conventional thinking, we draw upon the wisdom of turkeys and the existence of swans, specifically black swans.  What this has to do with the capital markets is detailed in the thought-provoking financial bestseller, The Black Swan – The Impact of the Highly Improbable, by Nassim Nicholas Taleb.

In our initial “Worth Mentioning” note last quarter, we wrote that the intent of this correspondence is to address a single investment topic from a fresh perspective.  As topics go, the headline above would seem a little ambitious for this format, but we’ll use this as a brief introduction to the compelling principles of Behavioral Finance.

Most investors are familiar with the claim “It’s different this time” - a siren’s song, often heard right before the inevitable collapse of whatever was supposed to be different. We heard it in spades with the dotcom craze. At its essence, it is a rationalization for chasing performance (against one’s better judgment) and is usually all you need to hear before knowing you need to go the other way – fast.