Bucks: How Rising Stock Prices Can Fool You

Carl Richards

Carl Richards is a certified financial planner in Park City, Utah. His sketches are archived here on the Bucks blog and on his personal Web site, BehaviorGap.com.

Missed in the heated debate last week over my post about gold was a narrow but crucial point: As the market value of an asset class increases, so does the risk.

While this may not apply to specific, individual stocks in all cases, it certainly applies to the market as a whole. I know this might appear obvious, but we don’t always act as if it is.

Think about this for a minute: Was the SP 500 more risky on March 6, 2009, when it was under 700, or is it more risky today, with the index over 1,300?

Now I realize, for example, that small-cap stocks are more risky than large-cap stocks. But when you consider small-cap stocks as an asset class individually, as the market value goes up, the risk of investing in that particular asset class increases.

The same thing applies to commodities, like gold. You’d be hard-pressed to convince a rational person that gold at $1,500 per ounce is less risky than gold at $500 per ounce.

It’s also fair to say that if we measure risk based on how we feel, almost all of us felt like the market was far more risky in early 2009 than we do today. As prices go up, the news seems better, people start to feel more comfortable and we equate that feeling of comfort with less risk. But that makes no sense when we think about it rationally, which is why investing based on our initial gut feelings can be so dangerous.

No one wanted to touch stocks in early 2009. There was no appetite for initial public offerings. Now money is flowing back into the equity markets and we’re all clamoring for shares of LinkedIn. And this, after a historic 100 percent plus rise in stock prices in a little over two years!

Please don’t misunderstand me. I’m not saying that the stock market is going to crash. I’m not saying that social media stocks represent a bubble (though others are suggesting it). I am trying to point out that as the market value of an asset increases, so the does the risk, and that it makes sense to at least think about that as you make important decisions about what you’re going to do with your life savings.

Article source: http://feeds.nytimes.com/click.phdo?i=3b8d21c13a49478791e5864a1f03d9a0