RISK BLINDNESS?

I live in a town with a lot of train tracks, so I frequently see people drive around the warning gates to beat the train. This got me thinking about just how they assess risk. I imagined if asked about their little train adventure they might say, “Risk, what risk? It's only risky if you get hit by a train, right?”. Psychologists call this thought process confirmation bias. The fact that the driver experienced the desired outcome confirms in their mind they made the correct decision. The reality is it doesn't change the level of risk they took or the probability of a bad outcome next time. Given the gravity of a bad outcome, was it really prudent? I see a lot of investors using the same logic when evaluating last years market performance. The S&P 500 index has a great year, largely due to its heavy weighting in large cap growth stocks. However, investors who believe those results came without substantial risk might be risk blind. When we experience good outcomes, we tend to downplay risks. This can be a critical error for investors. Markets have a habit of eventually bringing the happily oblivious back to reality.

So does the stock market currently have a high risk level? Today's situation is unique with risk appearing highly divergent between the growth and value sectors. During last years recession, one might logically assume the market would drop along with falling company sales and profits. Value sector stocks did just that, falling on average 2% - 6%. Meanwhile, the growth stock sector defied gravity with indexes gaining 35% - 45%, resulting in stock performance becoming significantly disconnected from the underlying companies economic fortunes. Another way to evaluate the logic of current prices is to compare a companies current stock prices to a years worth of company profits. We call this the price/earnings (P/E) ratio. It now stands at about 15 for value stocks, near the the middle of the historical range, leaving some upside potential as the economy grows. At the other end of the spectrum, growth stocks now trade at a P/E of 30 on average, at the higher end of their historical range. Growth stock prices can't indefinitely outrun gains in company profits. For these reasons I believe current price levels in this sector represent elevated risk and limited upside potential.

Overall volatility is bound to pick up in all sectors as investors come to grip with these divergences. My recommendation for long term investors is to continue over-weighting the value sector. It seems most closely aligned to our economic fundamentals with a more realistic risk/price profile.

Frank Rizzo, CERTIFIED FINANCIAL PLANNER TM

The opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The economic and market forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Investing includes risks, including fluctuating prices and loss of principal. All indices are unmanaged and may not be invested in directly. All performance is historical and is no guarantee of future results.