Easy money

When easy money becomes available, investors tend to take more risks with money that would otherwise lie idle.

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The risk of not diversifying

Few days ago, we explained the need for diversification: read the post here.

Now add to that three important points:

  1. The fall in the value of a concentrated portfolio as compared to a diversified one, and
  2. The investor behaviour of chasing the recent past performance
  3. At any point in time, at least one part of a diversified portfolio would outperform the diversified portfolio itself

These three statements mean a huge risk for most investors. Let us elaborate. First of all, at any point of time, the diversified portfolio would underperform at least one part of its own. In a bull market, especially, one sector would be leading the rally. This sector hogs the limelight. Since the performance is great, many investors invest in it only after seeing great past performance, which means most of the gains have been made and the prices have reached high levels. Buying costly is always a riskier proposition for investors as money-making opportunities are less of one buys costly. The faster rise is often followed by a steep fall. The leader in the rally is generally the leader in the fall, too.

since the investor missed out on the rally and entered at higher levels, there is disappointment for her.

Read more about some more examples in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget:

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Real v/s perceived risk

“The reason why most get it wrong in stock markets is that there is a gap between the actual risk and our perception of the same. Most of the times, the risk is at the highest when it is perceived to be at the lowest and vice versa. The risk of terrorist attack was actually the least after WTC event, but the whole of US was terrified”

Adopted from “The Mind of Wall Street” by Leon Levy

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Journey to the darker alleys

Risk is about an uncertain outcome. When one has taken a risk and been rewarded, we tend to believe there was no risk at all.

This leads to overconfidence in one’s abilities, which then leads to the search for even more risks. One tends to start looking at something that nobody is looking at – the spirit of adventure in us wants to seize the opportunity. And we leave the shores and dive into the deep seas.

From bluechips to mid-caps to penny stocks; or from downtown to suburbs to rural real estate; or from mutual funds to listed stocks to private equity – the journey to the darker alleys starts. If we have knowledge and expertise, it is ok to venture into these areas. Without that, it is dangerous.

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