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How to Take Advantage of the Risk Cycle

By: Steve Johnson

10/22/2008 - 59 Comments

If you look at a graph of the stock market for the last 100 years, you can see a pattern of boom-bust trends.

It seems like every 20-30 years of growth we have a recession that can sometimes last as long as 10 years.  The best economists in the world continue to try to come up with ways to stop bubbles from happening, yet here we go again. What is so illusive about controlling economic cycles?  There are central banks all over the world controlling everything from interest rates to money supplies to ownership of the national banks.  Yet, we face the largest global financial crisis since the Great Depression.

It seems as if no matter what governments do, they never seem to make the right decisions to stop the next financial disaster.  Governments seem to be unable or incapable of making the right decisions that result in long-term financial predictability and stability.  And it seems like too much risk is almost always part of the problem.  Whether it’s buying too many houses or to many tech stocks, the money seems to pool together into some asset class and create balloon prices that later collapse. 

This time, we may have a longer period of recovery because the asset bubble was based on our largest asset class – our housing market.  History is also not on our side, as other nations like Japan have taken upto 10 years to recover from a housing market collapse.

The cycle of taking higher and higher risks, seems to be at part of each economic cycle.  The long-term economic planners that study the risk cycle seem to come out the best when making investment decisions.  The key is to realize what stage we are in the risk cycle and how you can take advantage of it.

The Risk Cycle

Financial advisers always recommend diversifying your investment portfolio, but that is exactly what the smartest CEO’s in the world didn’t do when they led many of the largest banks and Wall Street firms deep into the sub-prime mortgage markets.

The problem with diversifying is that it drastically reduces your potential income. You can make a lot more money if you put all your chips into the hottest market like many of the largest financial firms did for many years.  If you choose to diversify, then lower returns reduce your ability to attract investors and your ability to grow your business.  The problem is magnified when your competitors create a competitive advantage against you by taking on more risk.

Competitive risk taking is very dangerous, because over time, everyone has taken on high risks with little cash to protect them from a pullback. Competitive risk taking is next to impossible to resist because if your business doesn’t take the extra risks, which will temporarily increase your profits, your investors will move money to your competitors.

Public traded companies operating with few competitors have no choice but to increase their risk and take part in the trend.  After the bubble bursts, everyone asks how could this happen?   The answer is that humans are like sheep in need of a Sheppard.  Once an asset is clearly on a run, everyone wants to get in on it.  That’s human nature. 

The Benefits Of The Risk Cycle

The businesses that have the vision to see the future of bubble asset prices and are able to convince their share holders that the trend is not a good long-term business strategy, are the one's that come out on top.  For example, Bank of America avoided most of the sub-prime market and is now the strongest national bank in America and has gobbled up a few of its competitors from the fallout. 

Sometimes a business just has to let high risk competitors take a few customers during a boom, while preparing for the bust. When the bust comes and the high risk competitors go under, your business will be there to gobble up the customers. This strategy is well understood and practiced by private owned businesses - that do not have to compete for investment dollars like publicly traded firms. This strategy provides a competitive advantage to private owned businesses - which are in the process of gobbling up market share and cheap assets.  This is where it pays to stick to your guns and wait for the market to turn your way.

This strategy can also be used when building a small business.  Be careful not to confuse this with going after new opportunities, but make sure each opportunity is not adding risk to your business.  Be careful not to build a business with the wrong customers, by giving away free (or cheap) products while adding cost and risk to your business.  If you cannot make a profit from a customer or if they add risk to your business, then you don’t want them. Wait for the market to turn your way.

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