Taking Advantage of the Fear Premium

By: Katie Keir for Advisor.ca
Scott Plaskett, CFP was interviewed to be a contributor to this article.

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When it comes to investing, the adage “If it’s in the press, it’s in the price” rings true. The market, often praised as a stable, distinct entity, is made of those who participate in it—when investors react, so too does the market.

Investing is perverse, according to Gerald Connor, chairman and CEO of Cumberland Private Wealth Management. When markets are down, investors believe that risk is elevated. In actual fact, however, risk has been reduced since the sold-off markets include a “fear premium” or discount—prices drop as events happen, rather than after, and investors shouldn’t fear further loss once prices have hit bottom.

“When the market reacts, it’s already based on the past,” says Connor. “The times investors perceive as risky and volatile are actually less risky, due to the fact that prices have already dropped and will most likely start to rise once again.”

For example, an investor may have a stock trading at $30, which is expected to go down to $20 in recession. If a downturn is forecasted, the stock drops to $25 and risk is already lower. When a recession hits, and the stock drops to $20, shareholders really start to worry.

But at that point, the recession is already a reality and is reflected in the price. From this point on, the price will likely rise and the stock will be worth more than $20 in the near future, allowing investors to not only regain capital, but also make a profit.

Connor stresses that when investors are attempting to time the market, they must be confident, and aware that the market is not linear and is not based on the past. They have to step back, analyze current trends and avoid getting caught up in the emotions of the wider community.

He cites Warren Buffett as an example of someone able to achieve this and find the confidence to participate in down markets—Buffett invested $24 billion in the third quarter of 2011, when markets were at their lowest. Investors like Buffett can ignore group fear, because they “understand that risk is a perception and not a reality, and can view the market and risk differently than the average person.”

The question is: can fearful investors learn to overcome uncertainty and take risks?

“Knowing what to look for and having the skill and confidence to pick are two different things,” says Connor. “Younger people may not be able to execute, but those who have gone through tough times, and who know that the paradox of investing is consistent, are able to pull the trigger and recognize danger signs.”

But timing the market doesn’t mean investing without a plan.

Connor emphasizes that all investors need a plan, and need to understand what they want out of the market. If your client is uncomfortable with volatility and isn’t looking to increase the risk quotient, help them find alternative pathways to achieve their desired level of return.

“How well can your client financially and emotionally withstand the market call process?” asks Connor. “Once out of their comfort zone, they’re prone to make a mistake and need to play within personal capabilities.”

Scott Plaskett, CFP at IRONSHIELD Financial Planning in Etobicoke, agrees that investors and clients “should not chase high yields and rates of returns, and should avoid investing without a solid direction.” In fact, he believes that timing the market and focusing on the fear premium leads to playing the market like a game.

“If you let emotions rule you, you’ll be wrong every time.” says Plaskett. “Investing isn’t a game. It’s a discipline that requires good habits, and the problem with the fear premium is that you are focusing on your emotions and other’s people’s emotions.”

He adds, “Instead, you should have a plan and a good, disciplined strategy that you are comfortable with. Pick an adequate rate of return and strive to achieve that instead of trying to outperform other investors and chase returns.”

Plaskett believes that when you time the market and actually start making money, it’s hard to remain logical and detached, citing examples of people who bet their retirement funds on Enron in the early 2000s, as well as rich investors who begin playing out of their league because they have the money.

The best way to successfully work in the market is to instead find an advisor you can trust, learn the complex language of investing and focus on what you know rather than what you think may happen.

“True investors do the right things during the tough times,” says Plaskett. “During the recession, So many people have asked ‘why should I pay someone to lose my money for me?’, but with some people losing up to 45% of their funds, seeking help will ensure you’re on the right track.”

Originally published on Advisor.ca