All investments have a certain amount of real risk that must be assumed when owning an asset. It is the risk perceptions of the market place (buyers and sellers) that determine the price of an asset.

The price of an asset may be greater or less than the intrinsic or real value of an asset. The difference between the real risk and perceived risk determines whether the price of the investment is higher or lower than the real value.

Mr. Market lets both his enthusiasm and gloom affect the price of investments. It is the goal of the value investor to take advantage of mis-priced assets.

Risk Investing Environments

The least favorable risk investing environment is low perceived risk and high real risk. When perceived risk is low the projected investment yield is low and and price of the investment is high. This combination provides a low expected rate of return (yield) with a high probability of capital losses (price).

The most favorable risk investing environment is high perceived risk and low real risk. When perceived risk is high the projected investment yield is high and price of the investment is low. This combination provides a high expected rate of return (yield) with high probability of capital gains (price).

While this analysis may seem intuitive, most investors do just the opposite. If you accept the markets judgment or perception of risk then you have accepted the long term return the market provides. Investments that are purchased when perceived risk is lower than the actual risk will produce poor investment returns in the long run.

The reverse is also true. Investments that are purchased when perceived risk is greater than the actual risk have a margin of safety built in. Investments made with a margin of safety greatly increase the odds of above average returns in the long run.

A perceived risk vs. real risk analysis can be employed at the Macro and Micro Level. Here are examples:

Macro Analysis of Perceived Risk vs. Real Risk

There are periods of time when prosperity and stability breed complacency and prices that far exceed the true value of entire asset categories. For example a macro analysis of the stock market may result in a different asset allocation depending on your perceived risk vs. real risk analysis.