If anything should have become clear these last few months it’s the critical importance of sound risk management.
It’s a lesson that tends to be forgotten by most investors at the tail-end of bubbles and re-learned the hard way when the bubble pops.
We forget this lesson after many years without a reminder and as everyone around us seems to be getting rich off skyrocketing asset prices. So, we chase performance without an understanding of risk or the extreme prices we’re paying for those assets.
In fact, about a year ago I shared a quote from J.P. Morgan that perfectly addresses this concept, “Nothing so undermines your financial judgement as the sight of your neighbor getting rich.”
I had a lot of people last year asking if we should be more aggressive, questioning if we were doing the right thing by being relatively conservative.
I consistently answered “yes” to that question because if we were relatively conservative there was a reason for it. Either (1) they didn’t have the financial capacity for the potential losses that could ensue meaning a certain level of losses would jeopardize their financial independence, and / or (2) they didn’t have the emotional capacity for the losses that could ensue, and / or (3) most risk assets were / are extremely overvalued (as I’ve written about many times).
Many of the trendiest assets that were being chased by retail investors (cryptocurrencies, meme stocks, overvalued tech stocks) are now down 70% or more from their all-time highs. Broad market indexes are down around 20% on the year.
Some people will respond, “But many of those assets are still up a lot from where they started years ago.” Unfortunately, that misses the point. The money invested in those speculative opportunities is relatively tiny early on. Bubbles suck money in near the top causing wealth to vanish when the bubble pops.
The prevalence of this boom-bust cycle throughout history is why I rely so heavily on time-tested economic principles…namely, that an asset’s price must ultimately reflect the long-term cash flows provided by the asset. Continue reading “This Year Shows Why Risk Management Is So Important!”
