High-end sports car dealers like to say brakes help the car go faster. How can this be, when brakes are meant to slow a car down (or bring it to a complete stop)?

The answer is that a world-class braking system makes it safer to accelerate and top out at higher speeds. If you know that you can slow down quickly and reliably, thanks to state-of-the-art braking technology, you will feel more comfortable stomping on the gas pedal.

In a strange way, then, a world-class braking system can make a sports car less safe — because the driver is willing to take bigger risks. This ties into a human behavior theory known as “risk compensation,” also known as the Peltzman Effect. It is relevant to many forms of risk-taking, including investor behavior in markets.

The Peltzman Effect is named after Sam Peltzman, a professor of economics at the University of Chicago Booth School of Business. In a controversial 1975 research paper titled “The Effects of Automobile Safety Regulation,” Peltzman argued that highway safety regulations were not reducing highway deaths.

In Peltzman’s view, this was due to “risk compensation,” where drivers who felt safer made riskier choices that canceled out the safety benefits. The phenomenon was recognized as common, and the Peltzman Effect was born.

The Peltzman Effect can be seen in many walks of life where safety measures and risk-taking are intertwined. Here are a few examples:

  • The increased reliability of high-tech skydiving, hang-gliding, and mountain-climbing gear has led enthusiasts to take more aggressive risks in those respective sports.
  • When jet ski patrols were introduced to big wave surfing as a superior means of rescuing stranded surfers, the big wave surfing community set its sights on larger, more dangerous waves.
  • When SUVs with four-wheel-drive technology boomed in popularity in the 1990s, snowstorm-related car accidents spiked in the years following due to driver overconfidence.

The deceased economist Hyman Minsky developed a theory that argues “stability begets instability,” which is more or less the stock market version of the Peltzman Effect.

Minsky’s core idea was that the longer the market feels stable and prosperous, the more comfortable investors become with taking on larger risks — and the level of riskiness keeps rising until things become unstable.

This also describes the boom-bust pattern of the business cycle, where extended booms fuel complacency and sloppy risk taking, which then leads to bad or risky investment choices, which then fuels a bust when the cycle turns.

After the bust, the bad investments are wiped out and everyone is more cautious. After a while, growth returns to the economy, optimism blooms anew, and this fuels the build-up to another boom.

For individual investors, the Peltzman Effect can become dangerous after long periods of low-volatility, low-interest-rate environments that make the stock market feel less risky than it actually is.

When markets appear sleepy and safe, and the conditions have lasted so long it feels permanent, the temptation is to load up on extra-risky investments, like high-yield junk bonds, or to take extra-large positions in stocks with high dividend yields. The perception of safety leads to more aggressive risk-taking. This can be fine if the investor is aware, but dangerous if they don’t realize what’s happening.

And it’s not just individual investors who fall prey to the Peltzman Effect. The same thing can happen to institutions on a mass scale. For example, there is a popular institutional strategy known as “target volatility funds,” where a mix of assets is rebalanced toward a standard rate of volatility.

The reason target volatility funds can be dangerous is because, when overall stock volatility has been low for a very long time, this strategy will load up extra-heavy on stocks, even for institutions that are highly sensitive to losses with a mandate that is very conservative. This increases the risk of getting blindsided when market volatility rises.

To guard against the Peltzman Effect in your own portfolio, there are two immediate steps you can take. First, make sure that all of your positions are sized properly; and second, be aware of the total composition of your portfolio, so that you aren’t lulled into complacency by too much exposure to a single industry or sector.

It’s not always bad to have heavy concentration in an industry, a sector, or even a small handful of stocks. Warren Buffett and Charlie Munger, for example, have done quite well this way. But as a rule of thumb, the greater the concentration you have, the more carefully you should track your exposure levels for both individual stocks and the portfolio as a whole, to guard against the dangers of the Peltzman Effect.

To help make this process easy, you can find simple-to-use position sizing calculators and portfolio composition tools in TradeStops.

For instance, when you’re ready to add a new stock position, you can use TradeStops to determine the optimal size of that position based on volatility considerations using the Position Size Calculator. And you can upload your portfolio details for a comprehensive, top down look at the composition of your portfolio using the Asset Allocation tool. These tools and more can potentially help you achieve higher returns with less risk, in part by guarding against the Peltzman Effect.

Richard Smith
Richard Smith, Ph.D.
CEO & Founder, TradeSmith