For these reasons, few market participants were afraid of losing money. Most just worried about missing opportunity. The unattractive outlook for stocks and bonds meant investors would have to be aggressive and innovative if they were going to earn significant returns in the low-return environment. Thus risk aversion (a) was unnecessary and (b) would be counter-productive. "You'd better invest in this new financial product," people were told. "If you don't, you'll miss out. And if you don't and your competitor does – and it works – you'll look out-of-step and fall behind." When contemplating a virtuous circle without end, investors usually think of only one word: "buy."
This describes the process through which fear of missed opportunity can overcome skepticism and prudence. And in this period, that's what happened. No one worried about losing money. Fear of missed opportunity drove most investors, and Citibank's Chuck Prince famously said, ". . . as long as the music is playing, you've got to get up and dance. We're still dancing." Although he worried about a possible decline in liquidity, he worried more about falling behind in the manic race to provide capita
Recent History – on the Downside
The events from mid-2007 through late 2008 or early 2009 demonstrate the reverse in operation. The upward trend in home prices ground to a halt and subprime mortgages began to default in large numbers. Leveraged vehicles melted down. Credit became unavailable, and financial institutions needed rescuing. Recession caused spending to contract, and corporate profits declined. Bear Stearns, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, Wachovia and Washington Mutual all required rescues. Bank capital, commercial paper and money market funds needed federal guarantees. After the bankruptcy of Lehman Brothers, people began to ponder the collapse of the financial system. As often happens in scary times, "possible" morphed into "probable," or at least something very much worth worrying about.
Now a vicious circle replaced the virtuous one of just a few months earlier. And with its arrival, the fear of losing money replaced the fear of missing opportunity. As I've said before, I imagine most investors' cry was, "I don't care if I ever make a penny in the market again; I just don't want to lose any more. Get me out!"
For most investors, no assumption was too negative to be true, and no potential return made the risk of loss worth bearing. High yield bonds at 19% yields. First lien leveraged loans at 18%. Investment grade bonds at 11%. None of these was sufficient to induce risk-taking.
As I wrote in "The Limits to Negativism" (October 15, 2008), "Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive." By the fourth quarter of 2008, risk aversion ruled and risk tolerance had disappeared. A skeptical view toward excessive pessimism was called for at a time of unprecedented low asset prices, but few people could muster it. The credit markets offered the highest returns in their history, but fear of losing money kept most investors from seizing the opportunity.
In the middle of this decade we saw a manic period in which losses were unimaginable. The resultant shortages of risk aversion and skepticism caused investors to buy at highs and assume unprecedented risks in order to avoid missing opportunity. This was followed – as usual – by a collapse in which no negative event could be ruled out and no return was high enough to induce buying, all because investors wanted nothing other than to avoid losing money.
This cycle produced a treacherous, low-return period in which it was very hard to find investments promising good returns earned with safety, and then a period of collapse in which there were bargains everywhere but few investors possessed the requisite "dry powder" and intestinal fortitude with which to buy. That's the background. Where do we stand today?
