Stocks and the massive misperception of risk

The past five years saw a massive mis-perception of risk that rapidly came to an end over the last several months.

What were seen as good risks by the largest investment banks on Wall Street (companies with control of huge amounts of capital) turned out to be very poor risks indeed.

That is as much of the story as most people understand, but if you probe a little further you will discover some important insights. The fact that a massive amount of capital was directed into instruments such as CDOs means that capital was not deployed to other opportunities.

Beginning in 2003, there was a perception that real estate investment was the ultimate "safe" investment, a mis-perception that was at the heart of the problem. Conversely, in the lingering psychic aftermath of the 2000-2002 bear market, stocks were perceived as very risky.

The graph above, showing global CDO issuance, reveals a massive deployment of capital into mortgage-related securities over the same years that stocks in general have performed sluggishly.

As risk has been re-assessed on a massive scale, capital may well flow back towards companies with a demonstrated ability to provide value to their customers and a history of being able to grow their business.

We have written before that ownership of good companies should form the backbone of any system for long-term growth of capital (see also this post).

As those controlling the largest capital pools reevaluate the risk landscape, they may return to the conclusion that we have believed all along. If so, it will be good news for well-run businesses positioned in front of fertile fields of growth.

For later posts dealing with this same subject, see also:

• "The Fed's oversteering and the wreckage of the past decade" 07/23/2009.

• "Ben Bernanke's non-New-Year's Resolution" 01/05/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.