10 Feb Out on the Limb

When I was a young boy I was playing with a friend out in a pasture that sometimes housed riding horses.  We were near a creek the horses undoubtedly frequented, when suddenly three or four of them appeared over a rise and came thundering in our direction.

Not being a horse person in any sense, I scurried up the closest old pine tree for safety.  Well, the limb held me just long enough for the horses to reach us, then snapped and down I came.  The rest is a bit of a blur, but I do recall returning to the site the next day to retrieve one of my sneakers that had been left behind in the mud.

This past year the stock market surprised us all.  In spite of uncertainty as to how the Federal Reserve would manage monetary policy, a struggling economy and stubbornly high unemployment, stocks rose to new all-time highs with rates of return exceeding 20%.  Why and how did that happen?

It happened because a great many investors chose – whether wittingly or not — to accept a higher level of risk than they had been willing to assume in recent years, in hopes for a better return than could be found in certificates of deposits, bonds, or other fixed-income vehicles.  It was what professionals in the industry term a “risk on” market.

Because so many people were willing to accept the higher risk posed by the stock market, demand for stocks rose, pushing prices higher.  No one person or group of investors caused the market to rise.  No one knew that it would do so.  And, no one knows what it will do in the year ahead.

No doubt, a lot of investors have climbed farther out on the risk limb than they know.  And, when it breaks off, they will not be prepared for or properly react to the fall.  Like my terrified flight from the small herd of horses who were most likely there for nothing more than a drink, they will scurry out of the market as it approaches bottom and into the perceived safety of money markets and CDs, leaving behind all the gains they had paid so dearly for by having climbed out on that limb in the first place.

Early in my career I learned that the only control we have over our investments are how much and what kind of risk we assume – and how much we pay in taxes and expenses in the process.  We have no control over returns, especially over the short term.

Whether it is a thundering herd of horses or the chaotic herd of investors and market mavens below us, it is not them upon whom we should focus our attention, but the limb upon which our security actually rests.  As you review your year-end financial statements, rather than dwelling upon the rate of return behind you, try to measure the level of risk before you, and make certain that the limb you are on is no higher above the ground than you can tolerate the fall.