Value investing involves searching for investments where the perceived risk is greater than the real or actual risk. Yes, we like high risk investments; that is high perceived risk!
All investments have a certain amount of real risk that must be assumed when owning an asset. It is the risk perceptions of the market place (buyers and sellers) that determine the price of an asset.
The price of an asset may be greater or less than the intrinsic or real value of an asset. The difference between the real risk and perceived risk determines whether the price of the investment is higher or lower than the real value.
Mr. Market lets both his enthusiasm and gloom affect the price of investments. It is the goal of the value investor to take advantage of mis-priced assets.
Risk Investing Environments
The least favorable risk investing environment is low perceived risk and high real risk. When perceived risk is low the projected investment yield is low and and price of the investment is high. This combination provides a low expected rate of return (yield) with a high probability of capital losses (price).
The most favorable risk investing environment is high perceived risk and low real risk. When perceived risk is high the projected investment yield is high and price of the investment is low. This combination provides a high expected rate of return (yield) with high probability of capital gains (price).
While this analysis may seem intuitive, most investors do just the opposite. If you accept the markets judgment or perception of risk then you have accepted the long term return the market provides. Investments that are purchased when perceived risk is lower than the actual risk will produce poor investment returns in the long run.
The reverse is also true. Investments that are purchased when perceived risk is greater than the actual risk have a margin of safety built in. Investments made with a margin of safety greatly increase the odds of above average returns in the long run.
A perceived risk vs. real risk analysis can be employed at the Macro and Micro Level. Here are examples:
Macro Analysis of Perceived Risk vs. Real Risk
There are periods of time when prosperity and stability breed complacency and prices that far exceed the true value of entire asset categories. For example a macro analysis of the stock market may result in a different asset allocation depending on your perceived risk vs. real risk analysis.
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 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 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
Successful 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.
Related Reading: Mr. Market and the Intelligent Investor