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It all seems so obvious: investors rarely maintain objective, rational, neutral and stable positions. First they exhibit high levels of optimism, greed, risk tolerance and credulousness, and their resulting behavior causes asset prices to rise, potential returns to fall,and risk to increase. But then, for some reason—perhaps the arrival of a tipping point—they switch to pessimism, fear, risk aversion and skepticism, and this causes asset prices to fall, prospective returns to rise, and risk to decrease. Notably,each group of phenomena tends to happen in unison, and the swing from one to the other often goes far beyond what reason might call for.

That’s one of the crazy things: in the real world, things generally fluctuate between “pretty good” and “not so hot.” But in the world of investing, perception often swings from “flawless” to “hopeless.” The pendulum careens from one extreme to the other, spending almost no time at “the happy medium” and rather little in the range of reasonableness. First there’s denial, and then there’s capitulation.∾

At the greatest extremes of the pendulum’s swing, a process can take on the appearance of a virtuous circle or a vicious circle. When events are predominantly positive and psychology is rosy, negative developments tend to be overlooked, everything is interpreted favorably, and things are often thought to be incapable of taking a turn for the worse. On the other hand, when things have been going badly for months or years and psychology is highly negative, it’s the potential for improvement that can be forgotten.

The superior investor—who resists external influences, remains emotionally balanced and acts rationally—perceives both positive and negative events, weighs events objectively, and analyzes them dispassionately. But the truth is that sometimes euphoria and optimism cause most investors to view things more positively than is warranted, and sometimes depression and pessimism make them see only bad and interpret events with a negative cast. Refusing to do so is one of the keys to successful investing.

Usually, when either set of polar extremes is in the ascendancy, that fact is readily observable, and thus the implications for investors should be obvious to objective observers. But of course, the swing of the market pendulum to one extreme or the other occurs for the simple reason that the psyches of most market participants are moving in the same direction in a herd-like fashion. (pages 98–99)

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My view that risk is the main moving piece in investing makes me conclude that at any given point in time, the way investors collectively are viewing risk and behaving with regard to it is of overwhelming importance in shaping the investment environment in which we find ourselves. And the state of the environment is key in determining how we should behave with regard to risk at that point. Assessing where attitudes toward risk stand in their cycle is perhaps the most important topic covered in this book. (page 103)

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Good times cause people to become more optimistic, jettison their caution, and settle for skimpy risk premiums on risky investments. Further, since they are less pessimistic and less alarmed, they tend to lose interest in the safer end of the risk/return continuum. This combination of elements makes the prices of risky assets rise relative to safer assets. Thus it shouldn’t come as a surprise that more unwise investments are made in good times than in bad. People are more inclined to make risky investments in good times even though the higher prices often mean the prospective risk premiums offered are skimpier than they were in more risk-conscious times. And when negative events occur, the lack of adequate risk premiums and margin for error shows the investments to have been unwise.

It follows from the above that risk is high when investors feel risk is low. And risk compensation is at a minimum just when risk is at a maximum (meaning risk compensation is most needed). So much for the rational investor!

For me, the bottom line of all of this is that the greatest source of investment risk is the belief that there is no risk. Widespread risk tolerance—or a high degree of investor comfort with risk—is the greatest harbinger of subsequent market declines. But this is rarely perceived at the time when perceiving it—and turning cautious—is most important. (pages 111–113)