Odd Perceptions of Risk
This idea of “risk” has always fascinated me for some reason. It’s as if, from day to day, we don’t view risk the same way. Many of us wouldn’t dare take the risk to travel in a car without our seatbelt fastened. Granted, partly because that is the law, but partly because we know that seatbelts can save lives. Did you know that you are about 20% more likely to die from unintentional poisoning than from a car accident? This means that for every 5 people who die from a car accident, there are 6 who die from accidental poisoning! Have you ever heard of such a thing? My point is that we guard against some risks and we ignore others because of the perceptions behind the risk. While it is more likely you will accidentally ingest, and ultimately die from, a poisonous substance than dying from a motor vehicle accident, we don’t all go around with a personal food taster, but most of us do wear seatbelts. Furthermore, we are about 86-times less likely to die from an airplane incident than from a car accident, yet many have the inverse fear that airplanes are much less safe than automobiles.
This inverse risk perception is witnessed in the investment world and it is a strange phenomenon. I’m going to do my best to explain this oddity in the following paragraphs, so let’s start with a little background for understanding.
Stock Prices and Valuations
Stock prices are determined by a market of those who bid for shares of a company to buy and those who will ask to sell shares at a given price. The bid-ask prices of shares. What determines the price of the stock is a function of the company’s value, profit, dividend, growth potential, and many other factors. To keep things simple, I’m going to only consider a stock’s current valuation and its future potential as the determining factor for the stock price. Let’s say that a company has a current value for all assets of the company – tangible and intangible, of $1,000,000. That is if the company were to sell all of its assets and pay all of its liabilities, it would have $1,000,000 remaining. Let us also say that this company has 10,000 shares of stock outstanding in the marketplace. This means that, simplistically speaking, the value of each share should be around $100. Again, this is simple terms to not get too complicated. If we believe that this company will grow its assets by 10% per year, then we should also believe that the stock will increase by 10% to $110, with all other things being equal. Therefore, it would behoove us to buy the stock at $100 and then sell at some point in the future when we have reached our required rate of return – which may be 10%. At $100 per share, let’s say that this represents a moderate level of risk. We can say that there is an equal chance that the stock will rise 10% or go down 10%.
Supply and Demand
To make things a little more complicated, I want to throw in the concept of supply and demand. Let’s say that this hypothetical company makes an electric vehicle that is seen as the top of the line in innovation in the automobile industry. Therefore, the belief by people is that this company will be the one company that revolutionizes the industry and becomes the prime innovator and market leader in their industry – all others will follow and try to emulate their products. So, seeing that the company is expected to do well over the next year, at least, and with the idea that this company will be the next “big thing” in a techno-industrial revolution, everyone wants in on the ground floor so they too can become filthy rich. So, with 10,000 shares on the market, people start buying as much as they can at $100 per share, but those who own the shares see that lots of people are bidding for those shares, so they start asking more for each share. Those who are more optimistic about this company’s prospects increase their bid to meet the ask price and pay a little more. Others see this and they increase their bid price, and, in turn, the owners start increasing their ask price. Before you know it, the price of the stock has risen to $200 per share. This supply and demand increase of price has, however, done nothing to the valuation of the firm. The company is still worth only $1,000,000 and still is only expected to increase its value by 10% within the next year. This means that the risk of losing money by purchasing the stock has gone up from a moderate level to now a much more likelihood of loss. Let’s say that this stock is now considered an aggressive risk with an 80% likelihood of losing value from the $200 level and only a 20% likelihood of increasing above the $200 mark. Now that people see that there is a greater likelihood of loss and a higher price to pay, they stop bidding up the stock and the current owners reduce their ask price in hopes of still selling at a profit. As the stock price drops, those who purchased at a high price, may spook, and decide they need to get out at any cost, just to be done with it and try again elsewhere. So, the price drops and may drop faster than it went up.
What People Don’t Realize
This is what happens when we see “hot stocks” and the next “big things” in the market. Companies like Tesla, Apple, Google, and many more throughout history have become the trending stock to make millions trading. What people don’t realize is the inverse nature of risk perception. When a hot stock starts its rise in price, the risk of loss increases too, however, investors often see an increasing stock price as a sign that the risk of loss is going down. And why not? If the price is increasing many will think I can sell it later when its gone up, but they don’t take into consideration other market forces that will eventually correct the out-of-control price and return the stock price to its natural valuation point – this is sometimes referred to as reversion towards the mean. The thing is that stock traders never really know when a stock may peak, or even when it may trough. They may not even have a good sense of where the true valuation for the stock is given that some of the value of the stock is determined by the anticipated growth rate of the company. Imagine expecting that a company would grow at 25% in 2020 and then COVID-19 shut the economy. Is that 25% still an accurate number or is it now -25%?
So, as stock prices increase at rates that are unsustainable, like currently being seen with Tesla’s stock, the risk of losing investment in the stock becomes greater. I read recently that if Tesla were to actually grow at the rate needed to substantiate its current stock price, it would have to go from producing it’s current level of around 400,000 cars per year to producing somewhere in the neighborhood of 3,500,000 cars per year and capture over 20% of the world’s luxury car market. Completely and utterly impossible – so this level of stock price for Tesla, currently, is unsustainable and will some day come crashing down once people realize the true risk they are taking, or once the next market cycle recession hits and the owners flee to the safety and security of value stocks, bonds, treasuries, and cash.
If people perceive risk to decrease when stock values rise to unsustainable levels, the opposite also holds true. When a recession hits and stock prices drop, what tends to happen? People panic, the news media reports that the sky is falling and people’s perception of stock market risk skyrockets. In actuality, the risk of ownership goes down. If the company’s fundamental valuation remains steady, i.e. – its revenues, earnings, expected growth, etc., then it becomes much more ideal to purchase the stock with the expectation that the stock value will increase. There is one caveat to this that is important, however. The company has to make it through the recession or market downturn. Some companies go out of business; that’s a risk factor, but if a company is well run and has good fundamentals it should be able to weather a downturn and continue on as a going concern when the market returns. Again, this is a reversion to the mean and when we look at the marketplace, as a whole, over the lifetime of the country, through good and bad, the market has always trended upward. So, when our hypothetical company that is valued at $1,000,000 has a stock price below $100, it’s being bought at a discount and all an investor has to do is buy it cheap and wait for the price to return.
It's rare that anyone without particular knowledge of investor behavior and investor psychology would actually know about this odd reality and that is why people tend to get into investment situations whereby they lose money. The concept is simple – buy low, and sell high, but when human emotion, behavior, and psychology get thrown into the mix, things can get wacky and irrational. That is why it is important to know that having an investment advisor is a lot more than simply deciding on what investments to buy and sell, its more about helping clients through the madcap world of investor behavior.
One final thought about investor psychology is this: An investor’s brain reacts no differently to the stock market than does the brain of a gambler, a cocaine addict, or a fool in love. So, you either better know that fact or get an unbiased third-party to help you navigate the reckless behavior that comes with it. And by the way, that unbiased third-party is known as a financial advisor.
Fortune Media IP Limited. (2020, August 29). Tesla has a business model problem: It can never justify its current stock price by simply making cars. Retrieved from Fortune: https://fortune.com/2020/08/29/tesla-business-model-cars-stock-prediction-electric-cars-evs/
National Safety Council. (2020, September 10). What Are the Odds of Dying From.. Retrieved from nsc.org: https://www.nsc.org/work-safety/tools-resources/injury-facts/chart