EC Why The Riskiest Stocks Have Been Vastly Outperforming Safe Ones

The Theory and Psychology of Risk

The conventional explanation as to why people invest in risky things like stocks is that they believe that the higher the risk, the greater the reward. If this weren’t true, the argument goes, everybody would invest in bonds. And certainly nobody would invest in such incredibly risky assets as cryptocurrency and the stock of nearly bankrupt companies if it weren’t for the belief that they could make themselves rich by doing so.

A case in point is Peter L. Bernstein’s Against the Gods: The Remarkable Story of Risk, widely considered the standard book on the subject. His perspective is the conventional one: “nobody takes a risk in the expectation that it will fail.” The only reason people take risks is because they have confidence that they can succeed. That confidence, of course, can be misplaced. But without it, no risks can be taken.

Or take Marc Gerstein’s cogent explanation of risk in capital markets:

In order to induce (bribe, if you will) anybody to invest in an asset that has any risk, you must offer an expectation that the return will be above the risk-free rate. There is no guarantee that any outcome will be successful, but you must be able to justify a before-the-fact expectation of a “premium” above the risk-free rate.

This standard argument is the foundation of risk-based economic theory. It underlies the Capital Asset Pricing Model, which is completely premised on the belief that expectations of risk correlate to expectations of reward. If the risk of a bet going wrong is certain financial death, then the expectation of reward has to be immense.

But this is simply not how people operate. Risk has its own psychological rewards that are completely unrelated to financial success or failure.

Red Bull is the poster child for this. Their entire marketing campaign is built around risk-taking for no good reason. The wallstreetbets followers are no different. Many of the GME buyers took the attitude that if they lost money, so what? It was fun being in on the gamble. There are no rewards for no-parachute skydiving or bungee-cord jumping. Go to Bolivia and talk to the folks who take mountain bikes down the death road. They’ll tell you: it’s the risk itself that is its own reward. If it weren’t the world’s most dangerous road, the number of folks who take it down would shrink radically.

And this attitude isn’t just limited to adolescent males. Look at the roster of Red Bull athletes. You’ll find old and young, men and women, fat people and thin people, rich and poor. Risk is fun for everyone.

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Alpha Stockman 1 month ago Member's comment

Great contrarian view.

William K. 1 month ago Member's comment

Quite interesting and certainly full of insight. The final evaluation that part of it is risk taken for the sake of risk is quite interesting indeed. That conclusion goes along with my assertion that at least part of the market movement is based on emotions. I do not say what kind because I don't know what is in people's heads. But clearly it is not fact based logic.

So it is nice to see that another has a similar opinion, approached from an entirely different direction.