In 2000 the perceived risk to the technology sector was extremely low and accordingly, prices were very high. Signs of a stock market bubble were everywhere. Prices had skyrocketed in a short period of time, the media was rampant with herd mentality including messages that “this time is different” and we were experiencing a “new paradigm”.
The low perceived risk was evident because of price. Technology stock prices were priced for perfection. Earnings and dividends would have had to grow at unsustainable rates for decades to justify the prices of individual companies. This would be the perfect example of a time to greatly lower your asset allocation to equities.
The opposite was true in March of 2009. The perceived risk in equities was evident by a herd mentality to sell stocks, a media that advertising the high risk of owning any equities, and prices that reflected fear of a complete collapse. This would be the perfect example of a time to increase your asset allocation to equities.
Micro Analysis of Perceived Risk vs. Real Risk
Regardless of the valuation of the stock market there are frequently opportunities and potential perils awaiting investing in individual assets. I will use Apple (AAPL) as an example because it well known.
In September of 2012 Apple was trading above $700 ($100 post split) at an all time high. The media was filled with stories from analysts that the stock could only go higher and $1000 was just around the corner. The perceived risk of owning the stock was at an all time low. Because the perceived risk of Apple was so low investors had drove the price of the stock to extraordinary prices. As usual the best time to sell a stock is when the perceived risk is low.
Less than 7 months later Apple stock was trading below $400 ($57 post split) accompanied by hundreds of media articles warning about the high risk of owning the stock. In reality the fundamentals of the company had not changed. What changed was the perceived risk of owning the stock. The risk of owning Apple at $390 was considerably less than at $700. Price matters.
Perceived Risk vs. Real Risk in Value Investing
Value investing is about purchasing investment assets at prices that put the odds of above average returns heavily in your favor. Excepting an investment that is going to go bust, almost any investment can be profitable if purchased at a low enough price.
The key to successful value investing is buying assets when the perceived risk is greater than the real risk. It’s equally important to avoid assets when the perceived risk is less that the real risk. No investor will be correct 100% of the time. However, your research and analysis of perceived risk vs. real risk is a crucial step to determine your asset allocation and individual asset purchases.
This article was republished with permission from Arbor Investment Planner.