In other words, visibility (and not necessarily the presence) of risk makes one cautious.

  Every time you go to the mountains, the driving skills of the local drivers amaze you. They navigate through the narrow, serpentine roads with ease. The discipline of giving way to an oncoming vehicle is what you don’t see often in the cities.

  While the drivers in the cities try to cut across lanes and overtake one another, those in the hills wait for opportunities and only then overtake.

  What do we achieve through this? Well, the vehicles travel at between 15 km / ph and 30 km / ph in the hills. How is this different from what we get in Mumbai? Even after all the attempts to outsmart the others, Mumbai drivers also get the same average speed. Trying to outsmart others does not cut travel time, but does cause traffic jams on the roads.

  How does one explain such a difference in the way people drive their vehicles? Is it that people in the hills have lots of time and those in cities have less of it? Could be. However, the discipline seems to be coming from visibility of the risk involved. Driving on those serpentine roads is quite risky and hence the drivers drive with caution. In cities, the risk of accidents appears low and hence drivers tend to seek risk in order to maximize the upside (of cutting the travel time). (This article is  only referring to the non-potholed Mumbai roads).

  This means, if the risk were visible, one would try to take precautions, but if they are not visible (irrespective of whether the risks exist or not), one is likely to be more aggressive. In other words, visibility (and not necessarily the presence) of risk makes one cautious. At the same time, if one is unable to see the clear and present risk, one tends to be aggressive.

  The key words in the previous sentence are “unable to see the clear and present risk”. It is not the absence, but the failure to see the risk.

  Why does that happen? Is it only the common men who cannot see the risk? Well, history suggests that even experts fall prey to such blindness.

  What are the possible reasons for such blindness? For one, it could be the inability arising out of a lack of knowledge of the subject. But a bigger one is the blindness caused by recent success.

  There was a similar incident at a sports event – ICC Cricket World Cup, 2011 – a match between India and South Africa.

  Indian batting was on a high note in the first 37 overs and cruising at more than 6.5 runs per over. Then India opted for the batting power play. Before the batting power play, Sachin and Gambhir were scoring at a decent pace and we had all raised our expectations of the final score. The team had also probably started dreaming about a score of over 350. That is why the team decided to take the power play and press the accelerator. This is where we will look at the risk and the perception of the same.

  Even when the runs were coming at a decent pace, once we took power play, both Sachin and Gambhir tried to be adventurous. Irfan Pathan, Yuvraj Singh and others also followed – not just back in pavilion but in playing rash shots. It was assumed that the power play would allow them to accelerate, but it was forgotten that it was the field restriction that was changing and not the quality of the bowling. The run rate could have gone up had the batsmen placed the ball in gaps and got boundaries as the outfield was very fast. Instead, the batsmen started playing riskier shots. Instead of considering that South Africa had a very strong bowling attack, the batsmen fixated on the chance that in a power play, the score can be increased and hence the shot selection resulted in the collapse of the strongest batting line up.

  The ease with which the runs were flowing, playing more aggressively looked to be too rewarding. At this stage, the risk-reward ratio looked favourably placed for being aggressive. This is exactly the way many investors perceive the risk when the markets are at dizzying heights. Taking aggressive positions looks to be a child’s play.

  Leon Levy has said in his book The Mind of Wall Street, “The risk is often at its lowest when it is perceived to be the highest and the highest when it is perceived to be at the lowest.”

  Even the experts forget this. What happened on Wall Street in the pre-2008 period was something similar. The majority of the experts relied on the infallibility of their genius and their risk models. The more complex the subject, the higher the chances of blindness caused by success.

  Benjamin Graham, the guru of investing, has also said in the context of investing, “the chief losses to investors come from the purchase of low-quality securities at times of favourable business conditions.”

  Be careful. While your investments are doing well, ensure you are not exposed to undue risks. When the historical performance of your investments is good, it might be time to become cautious.

  Let us go back to late 2007 to early 2008: the stock markets were frenzied, prices were skyrocketing. In such times, the majority of investors were throwing caution to the wind and investing in realty and infrastructure stocks (as well as sector funds concentrating in such stocks). Some investors took an aggressive stance and started investing in such securities on margin. A concentrated portfolio had done very well till then, but it was always a risky proposition. This was a time to pare down equity exposure, or at least keep the equity portfolio diversified across industries.

  A similar experience was awaiting investors at the end of 2008 when the Reserve Bank of India brought down interest rates as a response to the global liquidity crunch. From July 2008 to December 2008, debt mutual funds’ NAVs appreciated by around 6.5% and those of Government Securities funds went up by almost 20%. Anyone invested in debt funds or Government Securities funds looking at such returns faced loss after this. The fall in interest rates caused such a high return. However, the same fall in returns would mean poor returns going forward.

  In both the cases, an ideal approach would have been to rebalance the portfolio to a pre-decided asset allocation. This means, one would have booked profit in an asset class where the prices appreciated and added more to the one that had underperformed.

  Caution: please follow this rebalancing principle only for diversified portfolios and not in case of individual securities.

  Similarly, it is also observed that during good times, some “not-so-good” or financially weak companies are able to raise debt capital from public at high interest rates. While the going is good, the companies are able to service debt, but as soon as the tide turns against them, these companies default in their commitments. We saw a few companies defaulting on their commitments in the tough times of 2008-2011. Be careful about the credit rating of such companies. You may be better off earning low rates of return than putting your capital at risk.

  Take care.