Sunday, May 04, 2008

Properly Assessing Risk

The recent bubbles and crashes of the stock market, real estate, and securitized debt obligations have led me to the following observation: estimates of the future are often grounded in the present. For example, when real estate prices increased between 50 to 150% from 2003 to 2005 in some cities, people projected those price increases past 2005, and acted accordingly. The same is probably true for the 18% return of the S&P from 1990 to 2000. Unfortunately, this error in estimating the future may cause major issues in assessing risk for the following reasons:

  • People may underestimate risk when investments are going up. In the late nineties, people were making a killing in the stock market. A couple of colleagues shared that they made $60,000 in one day, or over a quarter million in a year. My guess is that these kind of results were not that uncommon.

    Of course, there were pundits calling for a catastrophe, but the average person wasn't. In fact, I remember people talking about taking a second mortgage to buy tech stocks. There were few conversations on whether the market could continue rising and I don't recall any conversations on the possibility of a significant decline in the market, other than for Y2K reasons.

  • People may overestimate risk when investments are going down. Currently, there are still a lot of people that wary about investing in the stock market. Either they had large losses from 2000 - 2002, or they experienced losses in the recent decline. In addition, the S&P 500 index returns have been flat for the past nine years.

    The classic phenomenon is when investors sell their stock holding near the bottom of a decline and just before the market resumes an upward trend.

  • To help avoid incorrectly assessing risk, a concept I like to use is regression to the mean, which proposes that returns will tend deliver the long term average, in the absence of an causal change. In the case of the stock market, with a long term return of 10%, I believe the last nine years may indicate that the stock market is due for a new upward trend. However, for housing , with a long term return of about 6%, I believe there may be several more years of declines or no increases for some cities, especially ones that had large returns in 2003-2005.

    For more on New Beginnings, check back every Sunday for a new segment.

    This is not financial, real estate or investment advice. Please consult a professional advisor.

    Copyright © 2008 Achievement Catalyst, LLC

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