For about a year, I’ve been sharing my realization that there are two main risks in the investment world: the risk of losing money and the risk of missing opportunity. You can completely avoid one or the other, or you can compromise between the two, but you can’t eliminate both. One of the prominent features of investor psychology is that few people are able to (a) always balance the two risks or (b) emphasize the right one at the right time. Rather, at the extremes they usually obsess about the wrong one . . . and in so doing make the other the one deserving attention.
But when people get excited about the prospect of easy money – even if from assets or investment strategies that have become far too popular, turning into overpriced manias – they frequently drop their risk aversion and adopt risk tolerance instead. Thus they swarm into the investment du jour without concern for its elevated price and risk. This behavior should constitute an important warning flag for prudent investors.In the same way that expanded risk tolerance accompanies appreciated asset prices and contributes to the risk of loss, so does risk aversion tend to rise in times of depressed prices, increasing the risk of missed opportunity. When people refuse to buy assets regardless of their low prices, they miss out on the best, lowest-risk returns of the cycle.