High Quality Assets Can Be Risky And Low Quality Assets Can Be Safe

When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price. • And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. No risk is feared, and thus no reward for risk bearing—no “risk premium”—is demanded or provided. That can make the thing that’s most esteemed the riskiest. This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them…. Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.

Indeed. 2012 was rich in examples of exactly the same phenomenon. We saw $AAPL falling 25% from its all-time highs just when $1000 seemed like a sure thing. We witnessed $AOL having its best year since the dot com times just when everyone had forgotten about them. We saw $RIMM and $FSLR double from their multi-year lows just when everyone had written them off. Those moves might turn out to be just temporary blips within a bigger trend, but they  left notable dent in the market’s consciousness in 2012. In all these cases, catalyst was not valuation, but extreme sentiment.

Sentiment could be a powerful contrarian indicator when it reaches extreme levels. Granted, “extreme” is difficult for quantify, but when paired with some basic  technical analysis tools, sentiment data could be a source of great trading ideas. Some of the best risk/reward setups come from failed breakouts and breakdowns. As the saying goes – “from failed moves, come fast moves” – in the opposite direction.

Source of the Quote: Marks, Howard (2011-04-19). The Most Important Thing: Uncommon Sense for the Thoughtful Investor (Columbia Business School Publishing) (Kindle Locations 1009-1016). Columbia University Press. Kindle Edition.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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