One Of Many Potential Reasons The Market Is Ignoring Risk

If you look at the crazy evaluations of numerous companies right now, it's pretty clear people are making bets that aren't taking risk into account. Perhaps you can make the argument a low percentage of the market actually utilizes risk in decision making when the markets aren't crazy as they are now, but I'm just going off where we currently stand. Why does the market choose to discard risk when buying equities or cryptocurrencies or whatever asset is going nuts right now?

A good start is to look at the affect heuristic. The first time I heard of this was reading Thinking Fast and Slow by Kahnemann and Tversky. The affect heuristic states that we weight our outcomes and probabilities based on if we like something or not. For instance, if we like technology stocks, we can come up with a host of great outcomes for how the tech will be used in the future, and dream about how many vacations we will be taking with our "f$^% you money" while downplaying the risk that is present.

When we dislike an industry, like say the tourism industry right now, we tend to have a more negative bias on the outcome of the industry. We "accept" that returns will be lower and we also weight the risk as being higher than if we liked the industry.

You can see how this can wreak havoc on how the market "feels" about a specific industry or stock. In the short term, the affect heuristic theoretically could do us a favor by allowing us to have a mindset that synergizes with the market. We can ride the momentum upwards. Unfortunately, reality will smack us upside the head at some point and show the market they swayed too far from taking the risk angle of the investment.

At that point, the market will do a 180. "This industry is garbage now." "I can't believe I thought this was a good company." "Sell, sell, sell." The stock price will plummet and people will be bearish on the industry and wax poetic about how risky it is to buy XYZ stock.

This is why you'll often hear that you shouldn't fall in love with your companies. It's hard, I know I have to fight it. But when you have emotions tied to your investments or your investment ideas you will make irrational decisions based on returns and risk.

Think hard!

Kyle