Risking it all with Vern

He was dealt four great cards. The jackpot depended on the next card. But before it was dealt, a shot was fired out in Nuttal & Mann’s Saloon in 1876, and Wild Bill Hickok hit the floor, dead from a gunshot to the back of the head. His four cards – aces and eights – were forever immortalized as the Dead Man’s Hand. It became the symbol of gambles gone wrong, where hidden risks outweigh the rewards.

Risk is a funny thing. Everybody loves it when it works out, but it can be quite painful when it doesn’t. I learned a lot about risk from a cat named Vern. Vern was a cat I had years ago; or I should say he had me. He wasn’t anything special; just an ordinary gray barn cat. But he was special to me, and he made me smile and laugh.

Vern was a house cat meant to live his life protected indoors. However, Vern didn’t seem to know this, and he never missed an opportunity to be out hunting for whatever it was that he liked to hunt. Unfortunately, in the real world, the hunter can sometimes become the hunted.

As long as Vern hunted during the day, the risks were fairly small. He almost always managed to come home around dinner time, carrying his trophy from the hunt, much to the dismay of everyone in the house. But night time was a different matter. The big hunters came out at night, the risks got higher, and the odds changed against him. As hard as I tried to prevent it, Vern often managed to find the right moment to bolt out the door, and he was out for the night. He always came home; although more than a few times he looked like he got the worst end of a fight.

I never understood why he would never abandon the thrill of the hunt in exchange for the comfort of watching TV and eating snacks with me in the easy chair, but that’s just the way he was. The good news is that Vern was lucky and lived a long and happy life.

This is not a story about Vern. This is a story about risk. More specifically, it’s about asymmetrical risk — when the risk in one direction is far greater than the other. This is the risk/reward equation people talk about but rarely consider.

Asymmetrical risk has nothing to do with the odds of a given risk, but everything to do with the consequences of a given risk. In Vern’s case, the odds that a coyote would kill him were relatively low, and the odds were more in his favor. For example, let’s say the odds were 50-to-1 in his favor. But the consequences of that risk were incredibly asymmetrical. In our hypothetical 50-to-1 risk, Vern returns home alive 50 times out of 51. But one time in 50, the coyotes kill him. By those odds, that’s a good risk. In reality, that’s a horrible risk. No investor would take a bet like that . . .at least not knowingly.

As investors, we should always be aware of risks, especially of asymmetrical risks. We should be wary of risks which are likely to work, but are likely to wipe us out if they don’t work. Understanding your potential reward is worthwhile. Understanding your potential risk is everything.

So here we are today with markets at all-time highs in the middle of a pandemic. What’s not to love? What could possibly go wrong? Well, the bears say plenty. Are we on the verge of a melt up (new highs) or a melt down? The bulls say stocks are expensive but have already priced-in the pandemic and are anticipating the recovery and a possible vaccine soon. Not to mention a few trillion dollars of government stimulus money with nowhere else to go. By that line of reasoning, stocks are not too high right now so there’s little chance of a big crash happening anytime soon. Really?!

First, even on normal valuations measured by price-to-earnings (P/E) ratios, stocks are as highly valued as they were before the last crash in late 2007. After hitting new all-time highs in February 2020, and then taking a 42 percent swan dive in four weeks when news of Covid-19 hit, we rebounded back to the hold highs and then some. If the rally continues, this would be the shortest bear market in history.

While I understand the rationale for saying the bad news is already priced in, can you really say that all the economic damage from this has already been understood and priced in? Think about that for a moment. I have a hard time buying that. Again, what could possibly go wrong?

How did Japan look in late 1989 before a two-decade downturn into early 2009? How did the U.S. economy look in late 1929 just before the greatest stock market crash in its history? How did the U.S. economy look in early 2000 before the tech wreck? And how did the economy look in late 2007 before the last great recession? As the old stock market saying goes, “They don’t ring a bell at the top” and let you know when it’s time to head for the exits.

I’m not suggesting the market is about to crash. I have no idea when that is coming. However, historically the market doesn’t go up forever without a correction. And this rally is running up among great uncertainty and in anticipation of many pandemic solutions that may or may not happen. Risks is always present. Be careful. My pal Vern beat the odds, but are you prepared if there is a correction? Thanks for reading.