Risk Assumption vs. Risk Aversion

It is said that markets area a constant battle between fear and greed.  I prefer to think of that relationship in less primal terms, with the daily movements of markets reflecting changing attitudes between risk aversion and risk assumption.  Those terms encompass the basic emotions that drive investor behavior but also offer a role for intellect.  Either way, the mood has certainly shifted.

About a month ago, I was privileged to speak at a well-attended investor conference in Las Vegas.  The event catered primarily to active individual investors, and the roster of speakers included some very prominent names.  I had several conversations with a wide range of investors.  Some were more experienced than others, but nearly all were well-informed and thoughtful in their approaches.[i]  Yet there was an inescapable underlying tone to many of the discussions – these investors were all willing to assume risk to achieve greater returns.

To be quite fair, over the past few years, that approach worked spectacularly well for many.  One speaker reminded the audience that he recommended Palantir (PLTR) at $6 a year earlier, and I wished I’d heard and taken that advice.  Several had.  But even as the markets were showing some initial signs of stress, most of the attendees were understandably more eager to hear about the next potential winner than they were about strategies to preserve their gains.  My mantra of “don’t fight the tape, insure against it” was politely received, but not necessarily the red meat that many wanted. 

Let’s just state it plainly: the prior two years were ideal for risk assumption.  Investors were justifiably excited about the prospects for a life-changing technology – artificial intelligence, of course – while at the same time were treated to the rare occurrence of rate cuts during a solid economy.  That’s a very potent brew.  Since emerging from a bearish run in late 2022, investors and traders alike contributed to a period of such solid momentum that virtually every dip could be considered a buying opportunity.  For the most part it was.  Under circumstances like that, where broad markets and the key stocks that powered them seemed move only upwards, of course one would want to buy as much as one could. 

Emblematic of that trend was the popularity of leveraged ETF’s, including the advent of those based on single stocks.  It is not uncommon on the IBKR platform for TQQQ, a 3x leveraged long ETF, to outpace that of the QQQ ETF upon which it is based.  The activities in 2X leveraged NVDL and TSLL are not sufficient to surpass perpetual leaders NVDA and TSLA, but they are often enough to put them among our 25 most active symbols.  When the Nasdaq 100 (NDX) was zooming, powered largely by the large surge in Nvidia and its peers, along with occasional stellar rallies in Tesla, it made sense for traders to overlook the disadvantages of leveraged ETFs[ii] in favor of the turbocharged rewards that they could offer.

But the love of momentum, and the thought that there was no better alternative to high-flying US tech stocks, blinded many to the changing nature of the investment environment.  Some investors took note of Warren Buffett’s moves to raise cash and reduce equity exposure, but others viewed him as old and out of touch.  Yet things have changed.  After the initial upswell of post-election enthusiasm, it appears that the new administration’s economic policies are more concerned – at least initially — with tariffs than the regulatory and tax relief that drove investor hopes.  Tariffs were not favored by many, and the peripatetic nature of their implementation has proved confusing.  Investors loathe uncertainty, and we now have a surfeit of it.

“When the facts change, I change my mind,” is a quote commonly attributed to John Maynard Keynes.   While it is not clear that he actually uttered that exact phrase, in 1924 he did write:

The inactive investor who takes up an obstinate attitude about his holdings and refuses to change his opinion merely because facts and circumstances have changed is the one who in the long run comes to grievous loss.

Markets and technology have changed dramatically in the century since the famed economist penned that statement, but human nature hasn’t.  Risk assumption and mechanically buying dips works fabulously when the trend is your friend.  But when trends change, so should investors’ tactics and their approach to risk.

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[i] One such conversation spurred my recent piece, “An Important Reminder for Options Traders!”, about why VIX options traders need to focus on the VIX futures curve, not strictly the spot price of the VIX index.

[ii] There are definite disadvantages to leveraged ETFs – (1) they also offer the potential for excess losses, and (2) they tend to underperform their benchmarks over time.  Regarding #2: this feature is usually stated clearly in their prospectuses, but people don’t always read them.  To achieve their leverage, they need to use derivatives.  That means they must buy options, which decay, or futures, which need to be rolled.  Both of those features negatively affect their long-term performance.