Assessing the stock market’s risk/reward opportunity is difficult at the moment. The economy’s future is uncertain, and the S&P 500’s recent rise means that many companies offer much higher valuations than they did a couple of months ago.
A potential recession may cause some investors to be downbeat about the stock market’s outlook. Other investors, in contrast, may focus on the prospects for growth as the economy gradually reopens.
One investor who experienced many periods of uncertainty during his career is Benjamin Graham. His focus on obtaining a margin of safety and controlling his emotions are likely reasons for his investment success over a long time period..
Managing risk
Avoiding risks such as the impact of a possible recession on stock prices is not a straightforward process. Even selling stocks and holding lower-risk assets such as cash carries the risk that your returns will be below inflation over the long run.
Therefore, a more useful strategy could be to manage risks facing the stock market, rather than to try and avoid them. For instance, diversifying your portfolio across multiple industries could reduce your dependency on a limited number of sectors to provide growth.
Graham highlighted that managing risk is one of the key tenets of investing: “Successful investing is about managing risk, not avoiding it.”
Controlling your emotions
The uncertain economic outlook means that many investors may be feeling cautious about the prospect of buying stocks. Even if they have managed to find companies with solid fundamentals trading at fair prices, their fear about losing money could prevent them from making stock purchases.
It is impossible to accurately predict the short-term direction of stock prices, and your gut instinct is likely to prove to be less reliable than company fundamentals in determining whether an opportunity is favorable from a risk/reward perspective.
Following your peers
At a time of economic uncertainty, it is tempting to look to your peers for help in assessing the risk/reward opportunity of a particular stock. This may be a sound means of obtaining information that you did not know about a company, but may not be a prudent strategy when it comes to deciding whether to purchase a stock.
Many investors allow their emotions to cloud their views about the stock market. For instance, in March, fear dominated the views of the investment community as the stock market dropped to a three-year low. Now that stock prices have rebounded, investor optimism may be misplaced if an uncertain economic period is ahead.
Graham was an advocate of being self-disciplined and making up your own mind about a company’s future prospects: “By developing your discipline and courage, you can refuse to let other people’s mood swings govern your financial destiny. In the end, how your investments behave is much less important than how you behave.”
Using investor sentiment to your advantage
Investor sentiment towards a sound business with a strong market position may be negative due to the short-term prospects for the industry that it operates within. This could produce a favorable risk/reward opportunity for value investors, due in part to the presence of a margin of safety.
At the moment, many sectors are unpopular among investors, such as retail and travel and leisure. This could mean there are buying opportunities for investors who ignore the emotional view and instead rely on fundamentals when making their investment-related decisions.
Graham previously highlighted the appeal of stocks and sectors that are unloved by most investors: “The best values today are often found in the stocks that were once hot and have since gone cold.”
Read more here:
- Seth Klarman on Seeking Value in a Rising Market
- Charlie Munger on Maximizing Your Returns in a Volatile Market
- Howard Marks on Investing After a Market Rally
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