Most professional investors and investment advisors are familiar with Kahneman and Tversky's Prospect Theory, developed in 1979 as an alternative to the Expected Utility Theory. The hope was to understand a psychologically realistic way that we humans make our financial decisions. You may have never heard of this theory, however, you, the individual and those of us who are professional investors are the actors that this theory is trying to recognize.
One of the observations that Prospect Theory recognizes is that people will actually take larger risks when they have experienced a loss. You can think of it this way; If you owned one of the major bank stocks last year at say $50.00 a share and today its $9.00 you have a deep desire to buy some more without any thoughts of whether the banks are even going to be in business next year. The gambler in you and the shame you feel for not selling last year have come together with such a powerful force that you do the one thing you should not be doing, increasing your risk.
Bank stocks are not the only place we are seeing this "risk seeking behavior" unfold in today's markets. The two most prominent are small company stocks and emerging market stocks. How can I tell? The S&P 500 has been on a roll lately with returns since March 31st of 8.56%. But take a look at the S&P 600, the index that represents smaller companies. It is up 14.97% in the same period. And even riskier, the S&P BRIC 40 is up over 19% this year. Not only have the highest risk common stocks increased at a faster rate than the largest most powerful companies, but even higher risk investments, namely "junk bonds" have gone up some 10% since the end of March.
All of you need to remember that prices are set in the short run by supply and demand. Currently the demand for investing has been shifting towards higher risk investments. Please - Please do not allow this risk seeking behavior to affect your investment approach. If you are thinking of buying or your adviser is recommended an emerging market stock fund, a small cap fund or a junk bond fund, have a better reason than hope of a faster recovery.
Intelligent Investing mandates that you understand the risk and dependencies you are taking with your money. With the current state of the world's economy, the highest risk of default is concentrated in the smallest companies in the smallest economies in the world. Are you sure you want to participate?
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