Types of Investment Risk: Market/Socionomic
Published on June 13, 2013
We are in the middle of a series breaking down the various types of investment risks. You can read the introduction here. We are posting one article covering one risk each weekday until the series is complete.
Yesterday we covered Fraud/"Madoff", and today we are covering...
Risk #4: Market/Socionomic Risk
Description: If the market sentiment for a particular investment materially shifts, demand can dry up relatively quickly and cause an investment to drop significantly in value. Every investment bears the risk that someone else may not be willing to pay what you just paid for that same investment. While an investment's value can be affected by any number of external or internal factors (natural disaster, economic shocks, operator risks, etc.), valuation risk is specifically tied to the swings of human emotion. Since it is ultimately human actions and desire that make markets, this is an ever-present risk of any investment that may need to be eventually sold.
Real World Examples: With the Great Depression, the financial crisis and ensuing Great Recession of 2008, the housing crisis, etc., assets that once held significant value were reduced in value considerably in a relatively short period of time. Blockbuster did not adapt to market conditions and RIM's Blackberry was left in the dust. Remember when Apple stock was priced at $700, on its way to $1,000? Markets change, aggregate demand shifts, and valuations can swing wildly as a result.
Extreme Avoidance Measures: Socionomics is the foundation of all investment value assignment and currency buying power. It cannot be avoided.
Potential Mitigations: Historical valuation ranges provide a context whereby investors can attempt to "buy low" and "sell high" based on the cyclical nature of valuations. When an investment reaches the lower end of its historical valuation range and if all other things are equal, this could be a time to take advantage of buying at what may end up being a discount, providing both better upside potential and downside protection.
Stay tuned, tomorrow's highlighted risk is: Dilution.