Is it riskier to invest today than a year ago?

A bright summer afternoon in a hill station, I was taking a stroll along the lake shore with few friends. A paddle boat operator approached us and asked: "Boating … want go out for boating? Half rate."

His offer was surprising because he knew us. It was our hometown. The natives rarely indulge themselves with activities that are a favorite among tourists. In a second, we realized why he was asking us. There was an accident in the lake a few days ago where a paddle boat sank along with three tourists. Even after frantic efforts of the divers, the bodies couldn't be recovered. It was big news in the sleepy little town. The tourists were scared and didn't want to go out to the lake on their own. There was widespread fear that the paddle boats were inherently unsafe.
The business of paddle boat operators came to standstill. They added a few safety measures like rubber tubes (life jackets weren't popular in those days) but it didn't help. So the offer from the paddle boat operator was essentially a confidence building measure. He thought if we take the boats, perhaps the tourists will follow suit.

We showed no interest. He sweetened the deal. "Ok take it out for free…all yours." We were smiling but uninterested. Then he started pleading, "Tourists are scared like sheep…take the boat…please." Half of my friends were already tilting towards a 'yes' when the boat man made the offer irresistible: " ride and free beer… enjoy."

So we went. Six people in six boats. And a crate of beer. It was a win-win deal. We had a gala time in the lake. It was completely free of traffic. We paddled, in formation, passing the beer and potato chips from boat to boat. We even did a boat race. As we returned to shore after a few hours of wild party, we could see tourist boats tricking back to the lake. In a few days, it was business as usual.

The story ends here. The question is, were we taking risks?

The answer is no. A risk is a risk before it is discovered and neutralized. Everyone who went on a paddle boat before the accident was taking that risk and three people paid for it with their lives. We were entering the scene after the accident when the boat operators had taken counter measures by providing safety rubber tubes. [drunken boating was definitely a risk but let's set it aside for now ]

I'm reminded of this incident in every market crash and subsequent fear wave that sweeps through the investing world. Two years ago, if you asked a 100 people: "Do you think investing in real estate is risky?", 99 would have said no. Ask the same question today and more than two third will answer in the affirmative.

In equities today, there are equivalents of the boat operator's free offer, i.e. buy at cash, and get fixed assets free. But the perception of risk is so high that people are ignoring the fact that there is a bigger margin of safety available today than there was in the last five years. Most people think that in investing, the risk-reward equation is such that the quest for higher returns always demands taking higher risk. It's a myth. The times when risks are highest are the times when the returns are lowest. Contrary to popular belief, for investors, the risks aren't highest at the time of recession, but they are highest at the peak of a boom.

The simplest logical explanation for this inversion of the risk-reward equation is this. When the risk appetite becomes bigger, the investors are willing to ignore the risks and that brings down the risk premium. The decrease in risk premium fuels the rise in prices. The value of each asset is driven by its fundamentals and there are limits to profitability of the companies. The higher the price, the lower is your return. If the best case scenario plays out in future, you gain a little because the expected profits are already built into the prices you paid. If the future disappoints, you my lose 80-90% of your investment. So the expected value of returns (probability-weighted sum of possible returns) hits a low exactly when you are taking highest risks.

This unintuitive result is a direct outcome of confusing the business risk with investment risk. If you invest in a business which is almost certain to grow, you are competing against millions of other investors who want a slice of the same cake. The desire to outbid the fellow investors results in a price which exposes you to a risk of having overpaid for the stock. Hence, a low risk business doesn't always translate into a low risk investment. You, as an investor, are subject to the business risks and valuation risks. If you don't take these in conjunction, you are bound to get negative surprises.

Similarly, high business risk doesn't always mean high risk for the investor. If the future profitability of a business is uncertain, yet you are fairly certain of it breaking even, you are taking very little risk when you buy such business below its net current assets after adjusting for debt. You are paying absolutely nothing for the profit potential of the assets. If by a stroke of luck, the company does well, you can get huge amount of returns.

People call this the 'contrarian approach' but I prefer calling it intelligent investing. The notion of going against public opinion doesn't excite me. If you ask a demented person to pick a correct answer among two choices, he will answer the question correctly roughly 50% of the time. You can't do better by merely picking the answer which he didn't pick. If you instead apply your own mind, you can get most of the questions right. So don't jump into buying the stocks just because everyone is selling them. Choose your investments carefully because choice is a luxury that has become affordable nowadays.

The world economy is in a bad shape. The markets have dropped to their lowest point in the millennium. A boat has sunk and no one is daring to venture out. Just take a stroll by the lake side and if you find a boatman giving you a free boat ride, take it.

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