On this episode of The Impatient Investor, Andrew discusses assessing the true risk of assets by scrutinizing the underlying economic fundamentals. Andrew encourages you to think about what makes economic sense and avoid following the masses.
“Going with the masses clouds the true risk of an investment causing us to underestimate the potential harm from such an investment strategy.”
2021 will be an unprecedented year and after 2020, a year like no other, where a pandemic upended society and the global economy, 2021 is poised to make waves as society prepares to rebound from the financial, social, and political fallout left in the wake of the virus. How will you rebound from 2020?
Critical to answering that question is your relationship to the word risk. Are you risk-averse? Will you hesitate to emerge from your literal and proverbial shelter? Are you ready to take risks? And do you feel like you have a good grasp of risk? Like animals, people tend to do things in herds because they think it’s safe. The common refrain is if everyone else is doing it, it can’t be bad for you, right? Not exactly. Generally accepted behaviors are often accepted as safe, but in reality, they may carry risks people tend to ignore because everyone else is doing it.
Fad diets are one of the biggest examples of this, people ignoring the risk because everyone else is doing it. The keto diet is the latest fad diet where risks are ignored. The diet involves cutting way back on carbohydrates to 50 grams a day or less and increasing consumption of so-called good fats like bacon, butter, and cheese to help the body achieve a state of ketosis in which it has to burn fat rather than sugar for energy.
The problem with the keto diet is it’s too restrictive to maintain long-term because of the potential heart problems and muscle loss that can occur, and for short-timers, once people stopped the diet most regained the weight they lost almost immediately. The problem with going with the masses is that the true risks of the actions are often ignored. If you look at the underlying fundamentals of the keto diet, it doesn’t make sense and it is outright unhealthy. Many health experts advise against cutting out an entire group of nutrients essential for proper health and nutrition. And by depriving yourself of this one key nutrient, carbohydrates, you’re essentially starving yourself they say.
Have you ever evaluated your investment portfolio and assess the true risk of your allocations? Or are you going to go with the masses ignoring the risks of a herd investment strategy? And are you avoiding other investments that the masses ignore because you’re told they’re too risky? Investors are piling into the stock market like never before. It could be a combination of financial desperation, boredom from lockdown-induced isolation, and stimulus money. Whatever it is, stocks are trading at irrational levels. The Dow is trading at nearly twice its historic average price to earnings ratio. Would you buy a local company at a price twice its underlying value?
It’s like when former Microsoft CEO Steve Ballmer paid over $2 billion for NBA team, the Los Angeles Clippers. Many industry insiders said he paid twice what he could have bought the team for, I guess he was taken over by his exuberance for owning a professional sports team. If investors look closely at the underlying economics of the stock market or scrutinize the broader economy, there would be no reason for stocks to be trading this high. Unemployment is still high, GDP is stagnant and 1000s are losing jobs from the current administration’s war on fossil fuels. The stock market is being driven by irrational exuberance fueled by some investors suffering from the fear of missing out and others going along because they don’t see the harm and something everyone else is doing.
As in the diet example going with the masses clouds the true risk of an investment causing us to underestimate the potential harm from such an investment strategy. On the flip side, we tend to ignore investments that the masses ignore and tend to overestimate the risks of these investments because our neighbors stay away from these sorts of things. Have you ever considered buying a business or investing in a real estate project? Why? Is it because we assume, they’re high risk because the masses ignore them?
For any investment, the only way to assess the true risk of an asset is to look beyond what the masses are thinking and to scrutinize the underlying economic fundamentals, investors are snapping up stocks of bankrupt companies. That doesn’t make economic sense. Investors are ignoring the risks of owning a worthless company. If investors looked at the underlying fundamentals and economic indicators and metrics involved with an asset, they would be leaving wall street and flocking to affordable housing. Did you know that affordable housing was the only sector that gained in occupancy and rents in 2020? Where other real estate segments faltered except for industrial, affordable housing thrived. And did you know that there’s been a shortage of affordable housing since the great recession? And that gap has only grown wider since.
Now does affordable housing seem like a risky investment to you? It’s time to get real with risk to look at the underlying metrics to assess the true risks of different investment opportunities. You’ll leave scratching your head wondering why people are pouring trillions into Bitcoin and Wall Street and not flocking to affordable housing.