Why you might be blind to your investments' risks

Investors may want to ask themselves whether all the excitement over the 2013 stock market rally has distracted them from looming risks. The Acertus Market Sentiment Index, a monthly measurement of investor attitudes toward risk, reported a 40% jump in risk tolerance at the end of 2013, putting today's market in the 86th percentile relative to historical measures of risk tolerance dating back to 1986, according to a new survey by Acertus Capital Management. “This is indicative of investors' growing willingness to accept increased risk, a trend consistent with recent media reports of increasing risk tolerance,” said Mitchell Eichen, founder and CEO of Acertus Capital Management, in a news release. Three of the five indicators that the AMSI comprises signaled concern. For example, price momentum, which measures the speed and magnitude of asset price increases, scored in the 86th percentile. Such a rapid and unyielding rise in prices can sometimes suggest that investors are experiencing “herd mentality,” unquestioningly “dumping money into equities to chase gains,” Mr. Eichen said. This stat was backed up by a very low reading for volatility, which is based on the standard deviation of S&P 500 index returns over the past 30 days. More fluctuation might suggest more-engaged investors, while a lack of volatility may suggest that “investors are getting a little lazy,” Mr. Eichen said in an interview. A similar measure, the CBOE Volatility Index (VIX), also suggests that investors are expecting low volatility going forward. Finally, stocks' price-to-earnings ratios are well above the historical average, according to Mr. Eichen. Two other measures were less problematic. The spread between the interbank lending rate and the yield on three-month U.S. Treasury notes is narrow, suggesting that investors see limited macroeconomic risk, Mr. Eichen said. The spread between high-quality and lower-quality debt is also quite low, in the 37th percentile, suggesting that credit risk isn't a major concern either. “I wouldn't rely on any one variable, but when several of these are moving together, it's a sign that investors might want to pay attention,” said Mr. Eichen. “This is telling me that investors might be getting a little sloppy, just putting money into the market and ignoring risk.” Indeed, money flows suggest that investors have warmed up to the idea of taking money out of bonds and putting it into stocks, the so-called Great Rotation. “One really symbolic event was the sell-off of Pimco's Total Return bond fund and the buying of stock, including Vanguard's mutual funds, which have now overtaken Pimco in size,” said Michael Rawson, a fund analyst at Morningstar Inc., referring to Pacific Investment Management Co. and the Vanguard Group Inc. But the rapid rise of equity values isn't necessarily a sign that investors are overly enthusiastic or blasé about risk, Mr. Rawson said. There are a number of reasons that current prices could be rational, including very low interest rates, strong earnings, high expected earnings growth, a lower risk premium and a reduction in the use of leverage, he said. “I wouldn't say that stocks are overvalued,” Mr. Rawson said. “Stock prices are not as high as they were during the tech bubble. More importantly, people back then thought that the market has fundamentally changed in some way. The attitude today is just that the economy is better, so now we can put our savings back in stocks.”