An Important Thing To Know About Stock Market Risk

A few days ago, I published Investing is Hard. In the article, I shared two things: 

• One, snippets of the State of the Union Address that two former US presidents, Bill Clinton and Barack Obama, gave in January 2000 and January 2010, respectively.
• Two, the subsequent performance of US stocks after both speeches. Clinton’s speech was full of optimism but the US stock market did poorly in the subsequent decade; on the other hand, Obama’s bleak address was followed by a decade-plus of solid gains for US stocks.

Here’s the snippet from Clinton’s State of the Union Address: 

“We are fortunate to be alive at this moment in history. Never before has our nation enjoyed, at once, so much prosperity and social progress with so little internal crisis and so few external threats. Never before have we had such a blessed opportunity — and, therefore, such a profound obligation — to build the more perfect union of our founders’ dreams.

We begin the new century with over 20 million new jobs; the fastest economic growth in more than 30 years; the lowest unemployment rates in 30 years; the lowest poverty rates in 20 years; the lowest African-American and Hispanic unemployment rates on record; the first back-to-back budget surpluses in 42 years. And next month, America will achieve the longest period of economic growth in our entire history.

My fellow Americans, the state of our union is the strongest it has ever been.”

This is the S&P 500 from January 2000 to January 2010:

The snippet from Obama’s State of the Union Address is this:

“One in 10 Americans still cannot find work. Many businesses have shuttered. Home values have declined. Small towns and rural communities have been hit especially hard. And for those who’d already known poverty, life has become that much harder. This recession has also compounded the burdens that America’s families have been dealing with for decades — the burden of working harder and longer for less; of being unable to save enough to retire or help kids with college.” 

The chart below shows the S&P 500 from January 2010 to today:

I think that Investing is Hard highlights an important idea about stock market risk: The riskiest time to invest is when everyone thinks there’s no risk; conversely, it’s the safest time to invest when everyone thinks risk is at its highest.

But why is this so? We can turn to the ideas of the late economist, Hyman Minsky, who passed on in 1996. When he was alive, Minsky was not well-known. It was after the Great Financial Crisis of 2007-09 that his ideas flourished.

That’s because he had a framework for understanding why economies go through inevitable boom-bust cycles. According to Minsky, stability itself is destabilising. When an economy is stable and growing, people feel safe. And when people feel safe, they take on more risk, such as borrowing more. This leads to the system becoming fragile.

Minsky was talking about the economy, but his idea can be extended to stocks. If we assume that stocks are guaranteed to grow by 8% per year, the only logical result would be that people would keep paying up for stocks, until stocks become way too expensive to produce that return. Or people will invest in stocks in a risky manner, such as borrowing to invest. But there are no guarantees in the real world. Bad things happen. And if stocks are priced for perfection in a fragile system, emergence of bad news will lead to falling stock prices.

The world of investing is full of paradoxes. The important idea that risk is at its highest when the perception of risk is at its lowest is one such example.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.