Friday, September 23, 2005

Risk aversion

Is it ever the right time to take risks? If you’re risk averse, the answer will consistently have been NO since the day you could walk.

Without overcomplicating things, risk aversion can simply be described as preferring safer returns, even if they are on average smaller. A person with this trait would be unwilling to take risks unless compensated for additional risk (beforehand) by higher returns. An example; bonds.

When the UK housing market crashed in the late 80s to early 90s, those that caught the property market on the up where lucky, though some were just savvy investors. However, a few years on, there are those who believed that the market would crash again. I am surprised to find out from conversation that there are some individuals who, to this date (25 odd years on), are still holding out to buy at the bottom of the market. Their conviction has obviously been reinforced by the 2000-2003 housing market rally and now they are ever more intent on holding out to buy at the bottom of the market. However, those that bought in the early 90s, whether savvy investor or just "lay-man", are now quids-in (in the money) because almost 25 years later, the market has taken a different shape, some property prices having risen by around 150% over 25 years. The risk averse may well be bitter but they surely missed that boat.

Now with the property market in stagnation, there is now a stand-off between the buyers and sellers. Those who want to buy are frightened about buying at the summit of a very high "mountain" (and have very valid reason to do so) and those that bought are hell bent on making some money and so won’t sell.

Does the same context of risk aversion apply in this case for those waiting to buy?

One thing is for sure, the ride down the "mountain", when it happens, will be quick and recovery from it will take a long while (because once consumer confidence has been dented, it's like waiting for a knocked out boxer to stand-up. When he does is anyone's guess).
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But, will the market rise any further?
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Two years ago, the prospect of higher rises was laughable, but the market rose regardless. It would be unwise however, to base future price expectations entirely on historic data, especially in a the property market where a lot of the "traditional" relationships between indicators have been breached by more than anyone dared to imagine.

Is the risk averse individual vindicated this time around or is it simply a case of "it’s never the right time"?
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Bond markets are doing pretty well, obviously driven by an element of risk aversion as bonds are supposed to be the safest assets to hold. But on the other hand, the FTSE all share index has risen by more than 10% since May, which implies that equity prices have been rising, a sign that investors are taking on more risk. These two facts provide two conflicting views about current investor sentiment.
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Since one cannot foretell at what/which point to jump onto the bandwagon, one cannot foretell whether an investment will turn out to be a loss. The consolation is that financial markets are advanced enough to be termed as near efficient, which means that asset price action covers all relevant information. Those that take high risks (accept a lot more uncertainty) like in owning emerging market debt instruments, get higher pay-offs but can also make higher losses.
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If you don't already own a house, would you buy one now?
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The UK mountain (from housepricecrash.co.uk)
Of course I accept that you just want a place to live in and are not particularly interested in the investment side of it BUT buying at the high of the market gives you a higher mortgage debt burden until such a time (from now until 10-20 year on) that house price inflation erodes your debt in real terms.
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Right now, the cheap/good deals are gone and all that's left is what is at the top of the market. Mortgage lenders have had a many good applications, have secured a lot of future income and can now be very picky (all signs that you are at the top of the mountain).
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Would not buying now be termed as risk aversion or as appropriate prudence?
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Beyond a certain level of risk, the returns begin to look rather uncomplementary to the downside.

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