If Memory Serves

As Jason Zweig wrote in the commentary of The Intelligent Investor, “Daniel Khaneman and Amos Tversky have shown when humans estimate the likelihood or frequency of an event, we make that judgement based not on how often the event has actually occurred, but on how vivid the past examples are.”

The Great Recession is moving further back into history every day, and with that, all other past financial events. As each day passes, it seems like recent history is more characterized by low volatility and a slow, yet steady, climb in asset prices than all out panic. Luckily, many analysts keep tabs on the frequencies of recessions and past financial panics. This reality check may help avoid the pitfalls of going with the crowd when euphoria sets in. Now, it would be easy to say most assets classes are overvalued and it is about time we saw some volatility, but it is important to keep in mind that there has been almost 10 years of Monetary Alchemy being practiced- most of which has not been experienced in recorded history.

So as old memories fade and new ones are created, it is important to remember that we are in an reasonably extended cycle and investors are caring less about risk than return. This is evident in spreads on bonds, the lack of protections bond-holders are demanding, and the narrow discount levels at which closed-end funds as a whole (due to their high yield) are trading at.

The economy keeps printing satisfactory reports it is hard to argue that there is any immediate need to divest or protect with alternatives, yet complacency is a characteristic of the calm before the storm. To be frank, the storm could be as gentle as a sprinkle that extends for years, but as we know, the next one always comes. As ‘bearish” as this may come off, prudence and protection of capital are of the utmost importance and while the number of “bearish” newsletters is declining rapidly as a percentage as a whole, it seems fitting to provide a counterargument.

In total, despite the apparent health of the economy, it would be wise to acknowledge that investors, as a whole, are accepting a diminishing margin of safety as each day of this recovery proceeds. This may seem small on a daily basis, but despite economic health, any time risk is put on the back burner for reward, we must be prepared to face the music. So as our memory of financial downside gets boxed up and stored away, and as younger investors enter the field unknowingly, what is important is that we invest with a careful eye toward risk and a margin of safety so that when our memory is refreshed we are prepared.