Similar sentiment was expressed back in the late nineties about Internet-related stocks, especially in the United States of America. The pinnacle of optimism came with the publication of "Dow 36,000" on Oct. 1, 1999 (coincidentally near the peak of the tech bubble), co-written with economist Kevin A. Hassett.
The book called for stocks to triple in as little as five years. That said, the book contained some sensible, eat-your-vegetables advice: diversify, trade as seldom as possible and keep your costs low.
But the main argument of "Dow 36,000" was dubious.
Three days before "Dow 36,000" came out, Foundry Networks, a computer-infrastructure firm, went public; its shares shot up 525% on their first day. Over the preceding five years, US stocks had gained an annual average of 25%. Nevertheless, "stocks could immediately double, triple or even quadruple and still not be too expensive," wrote Messrs. Glassman and Hassett.
Their logic? "Stocks and bonds are equally risky over long horizons," because stocks had never lost money over the long term, and the passage of time made their rate of return almost constant. Furthermore, investors had started "learning" that stocks weren't risky.
On reflection, the authors’ argument wasn't radical. In one way they were right: Economists contend that riskier assets must offer higher returns, or no one would invest in them. That is a fallacy, and a dangerous one at that.
Riskier assets don't necessarily offer higher returns; they only appear to do so. If risky investments could be counted on for higher returns, then they wouldn't be risky. And if investments weren't risky, then they probably wouldn't appear to promise higher returns.
By chasing the potential for higher return in riskier assets, investors drive prices up. Under the classic definition of risk—how widely the returns deviate from the average—that alone doesn't make assets more dangerous. But by using a common-sense definition of risk—"the likelihood of losing money"—rising prices are pure investment poison.
The higher and faster prices go up, the farther and harder they have to fall. But that’s not to say that investors should rush out of all risky assets and relocate under a huge rock. Nor should wise investors subscribe to doomsayers who preach about the next disaster that’s going to end civilisation as we know it.
Is the world more dangerous than in 1999, when the "Y2K" glitch threatened computer networks and suicide bombs were a weekly spectacle during “peace” and wars raged in Kosovo, Rwanda and Sierra Leone?
Hedging may provide investor portfolios some security against "known-unknowns", which has always been true. But it’s the “unknown unknowns”, which always gets everyone. And no holding period is long enough to eliminate the risk of holding stocks. Research from Elroy Dimson, Paul Marsh and Mike Staunton of London Business School shows that stocks world-wide have sometimes lost money, after inflation, for many decades, as in France from 1912 through 1977. Such a long slog isn’t quite impossible here, especially given the disappointment circa 1993 through 2002.
The risks of owning stocks are real, and they are rising—not falling—as stock prices keep going up. That doesn't mean you should reduce your exposure to stocks. It does mean the more they go up, the less you should like them. But above all, you should understand how each company makes money, what business lines they are in and their relative strengths.
The biggest movers of late in the domestic market seem to be trust companies, with limited or no liquidity and dubious business models without any explanation of how they make money.
Much is expected of new IPOs during 2011. If proper businesses that engage in activities which generate cash-flows and profits don’t make it into the bourse, stocks will get more risky, not less—and less attractive, not more.
(Kajanga is an Investment Specialist based in Sydney, Australia. He wrote this column during a holiday in Sri Lanka. You can write to him at firstname.lastname@example.org.