Untangling Fear and Risk: An Investment Survival Skill

Baron Rothschild famously advised investors to “Buy when there’s blood in the streets even if the blood is your own.” This seemingly counterintuitive advice is anything but. When market participants are scared, prices will be driven by anger, regret, blame and fear. These emotional inputs to short-term price fluctuations create opportunities for clear-headed investors. Warren Buffett and Charlie Munger attribute their investment success, in part, to being fearful when the market is greedy and greedy when the market is fearful.

Fearful markets are fascinating partly because they do very little to anticipate future risks and opportunities. Rather, they react emotionally to events that have already happened. And when the link between current prices and future risk is broken—when prices reflect regret, pain and blame induced by events in the past instead of rationally discounted future cash flows—alpha opportunities emerge. But it does require that you behave more like a cold calculating machine rather than a heart-on-the-sleeve human.

This so-called “fear premium”—the alpha opportunity created by fear-driven markets—is well-studied and understood. I want to give credit to my mentor and old partner, Rob Arnott, for coining this term and introducing it into the popular investment lexicon. Despite the advice from investment gurus like the Omaha Oracle himself, few investors have the discipline to avoid fear-induced behavioral mistakes. Truly, few can distinguish between backward looking fear and forward-looking risk.

The Difference Between Risk and Fear

“Risk premia” and “fear premia” are separate but related concepts.

A risk premium is the discount in price that investors receive for bearing risk of holding a security with uncertain future cash flows and prices. This discount leads to higher expected returns than holding safe assets like bank deposits. The higher the risk, the higher the risk premium and thus the higher the expected return. In investing, there is no such thing as “this asset is so risky as to be uninvestable.” Instead, the question is only ever whether you are receiving sufficient “risk premium” for your trouble.

In a perfectly efficient market, the price reflects only the relevant forward-looking cash flows and risks. However, markets are rarely, if ever, perfectly efficient. Behavioral biases are well-documented for retail and professional investors alike. These behavioral biases are especially large during times of euphoria or crises. In bear markets we observe prices that (substantially) reflect investor regret, self-loathing and blame caused by negative market shocks. The emotional distress for existing shareholders often leads to irrational selling as a way of ending the pain and fear that would otherwise disrupt one’s sleep and appetite. Selling isn’t about seeing a future that will be far worse than the price already suggests; selling is to forget, to escape, to find closure—to move on. You might argue (with yourself) that your decision to sell was a prudent move to manage your downside risk. But the truth is that you are pain managing not risk managing.

Risk managing is rebalancing when your high-flying stocks hit indefensible valuation levels such that new metrics need to be invented by analysts to justify the price. Prudent risk management is taking profits when the incorrigibly optimistic sell-side analyst upgrades the price target for a disruptive tech stock from $120 to $200 when it is already trading at $400. Sound risk management is to risk-off when the market is greedy, when prices are determined by users of Reddit and Robinhood.com, when a stock like GME runs from $10 to $300 in 2 weeks, or when a practical joke like Dogecoin reached $10B. Good risk management is selling after China has produced world beating stock market returns of 70% after its initial draconian Wuhan lockdown, not after the 30% decline when COVID reminded the CCP that nature would not be so easily tamed. Selling after prices have collapsed is pain management, not risk management.

The News Cycle Reinforces Our Instinctual (Harmful) Behavior

In bear markets, newspaper headlines are written to comment on recent negative events and to give color to the price declines. They are automatically negative and often sensationalized for effect. Most investors tend to mistake news headlines as forward-looking insights. But prices already reflect everything in the news. Headlines are lagging indicators and backward looking, but inexperienced investors confuse them for predictive signals. In the declining phase of a bear market (before what chartists call the capitulation and the bottoming out), investment talking heads muse about market sentiment and how headlines drive prices. We stop talking about future cash flows and valuations. Buffett and other successful long-term investors have advocated turning off CNN and your Bloomberg feeds to stop yourself from falling into the behavioral trap of over-reacting to public news, which are more than priced by the time you read them. Indeed, by the time you read them, they have mostly become bias-confirming noise.

Transforming Fear Into Alpha

Taken altogether, when prices are hugely driven by a focus on realized risks, which were previously ignored, but now have smacked us upside down and are fully priced in—in those markets the discount in prices reflect not future unrealized risk but current fear. The excess fear premium offered by common market participants is what rational investors capture as alpha. Some of those rational investors are people who are missing a neural pathway, preventing them from experiencing fear (this is confirmed in a study using MRI). Others are professional investors who follow a highly disciplined process—investors who are able to turn off Cramer and other sources of financial entertainment, recognizing that they are siren songs not guiding lights.

In a paradoxical way, the fear premium generally increases as forward risk decreases. For example, if the China market has dropped 30% in the past 12 months, the risk that it will drop another 30% in the coming 12 months is less likely. This is because, in bear markets, as prices fall, not only do they reflect negative earnings shocks they also rapidly compress valuation. Low valuation then acts as a floor and often predicts better future returns. Similarly, when prices decline because of government policy mistakes or management execution shortfall, the future isn’t more incompetence. We generally find adaptive systems within most forms of governments and corporate governance. Policy and management mistakes are followed by corrective actions to remedy the mistakes. People learn and organizations learn; they iterate and improve. Those who don’t are often replaced. Not always, but the pattern is strong.

Fear Premium is Not About “Timing the Bottom”

No investor, fund or firm has ever demonstrated a persistent ability to “time” the bottom of a market, but people still believe they can. Unfortunately, there is a difference between reality and wishful thinking. As a practical matter, the people who wait and wait for data to confirm the bottom of a market usually miss out on a good portion of a sharp market rebound. It should come as no surprise, that by the time headlines start to turn positive and earnings begin to surprise to the upside, or in other words, when all the reasons for fear are gone, the fear premium will have also evaporated.

Hong Kong’s response to the SARS crisis is a useful and particularly apt analogy. Much like China’s zero-COVID policy today, Hong Kong took a draconian approach to the crisis, locking down the city which pummeled the Hong Kong stock market. But the market bounced back sharply even before it became clear the SARS crisis was contained and restrictions would be lifted. Those who sat around waiting for confirmation of the “bottom” before investing would have missed out on a significant rebound.

Market timing as it is practiced is almost always a losing strategy. As the famous saying goes: “It is far easier to buy at the right price than it is to buy at the right time.” Most people who want to buy at the perfect time seem too often to end up chasing in at a bad price.

So, the million-dollar question to ask yourself now is whether you feel your target investment market is being driven by greed or fear, and to what extent? Is it time to buy the US? Is it time to buy China? I don’t know for sure. What I do know is that China is largely labelled as “uninvestable” and has seen the largest outflows (as measured by domestic Chinese mutual funds and U.S. mutual funds selling through the Hong Kong connect program). On the other hand, Cathie Wood is still the Queen of disruptive future technology, keynoting investment conferences talking about the 50% expected returns for her active fund. She is still the biggest inflow draw!

Fear Premium in China

The fear premium is not unique to any market. But many people do read The Bridge for insights on China, so let me share my general thoughts.

It is useful to point out that the risk of investing in China isn’t much different than it has ever been. China continues to be a one-party, autocratic government. Honestly, China’s various governments over the last 5000 have all been a bit like that. XJP has been in power for 10 years and has communicated his ambition for a indefinite term long ago. Chinese regulators have always been interventionist and experimental; their trial and err—a method that visionary tech leaders in the US refer to as iterating toward the right solution—often feels like two steps forward and one step back. Their ADR companies have always been under scrutiny by US regulators for the questionable corporate chassis and the resulting transparency issues. The A-shares market has always had 25% volatility, far higher than the volatility of an average US stock; even the mega cap tech stocks are meaningfully more volatile than US tech shares; a concentrated portfolio of a few China tech names was predictably going to have some nasty drawdowns and even wipeouts. China has always struggled with ESG as defined by the West. If any of these things surprise you, you just weren’t paying attention; risk didn’t become larger recently.

To be fair, China is not unlike other EM economies. We don’t invest in EM economies because they are like the US or other DM markets. We invest in them because they are very different, and the difference often comes with a meaningful risk premium even as it also provides diversification through low correlation and hopefully, superb growth.

Contrary to the claim of China equities becoming riskier, in nearly every way, investing in China is less risky than it was ten years ago. There is far greater liquidity; there is the Hong Kong connect program which allows you to invest in thousands of onshore companies diversified across every major sector and sub-sector (instead of just tech giants offshore); the regulators are more experienced (they have weathered their own deleveraging crises and other mini-crises); there are more global institutional investors helping with price discovery and market depth; the management teams of the listed companies are more seasoned (with poor ones eliminated over time); and China’s ESG improvements have been head and shoulders above other EM economies and DM countries.

I think it’s very difficult to make a compelling case that investing in China is riskier today than it has been in the past. When people say China is “uninvestable,” what they mean is that they bought an undiversified basket of Chinese tech stocks which have fallen a lot, and they are really angry. It certainly can’t be the investors’ fault for not understanding the risks of concentrating into China tech ADRs. Instead, they blame China for becoming riskier without warning, and they need you to be angry in sympathy.

Wrapping Up

I don’t think I can summarize this piece any better that Baron Rothschild’s quote already does, “Buy when there’s blood in the streets even if the blood is your own.” But perhaps I can offer a corollary of my own, “Sell when there is celebration in the air, even if you’re hosting the party.” Perhaps by keeping these quotes in your mind as you assess markets and rebalance your portfolio will make you a bit more suspicious of your instincts and skeptical of the advice streaming in from pundits. Stay disciplined and look for unloved, fear-driven markets with good fundamentals. It may not be a comfortable portfolio, but to end on another quote (again from my long-time mentor Rob Arnott), “Doing what is comfortable is rarely profitable.”