Risk is one of the most important and yet misunderstood concepts in the investment industry. Although most of us realize that it is the probability of permanent loss or injury, our perception of this probability can change dramatically based simply on what others are doing.

For example, most people take less risk during turbulent times while everyone is heading for the exits but are willing to take on more risk during periods of euphoria with a sense of confidence bolstered by the excitement around them. As a result, investors often wind up chaising near-term returns as the fear-of-missing-out (FOMO) takes hold.

The problem is that returns are often quite dynamic: they change based on investor demand, which can alter the relationship between the price of an investment and its underlying fundamentals. Tight supply can compound the situation. In cases where supply is extremely limited, what started as “investing” can morph into a pyramid game in which the main goal is to find another buyer willing to pay a higher price than you did.

In order to avoid such situations, it’s important to take a step back and compare an investment to other areas of the market in order to effectively grasp its merits.

Currently, there are at least two areas in which we believe investors should be wary — marijuana and mortgages.

In the case of the marijuana sector, there is no shortage of euphoria — just look at how legalization dominated the headlines last week. While we have no problem investing in high-growth stories, the problem is that the cannabis sector doesn’t fit the description, given that valuations have eclipsed the total size of the expected market.

Specifically, the sector as a whole has a market capitalization of more than $50 billion versus a fully built out annual revenue projection of $5 billion to $7 billion in Canada. We have personally seen companies with $5 million to $15 million in assets go public and obtain a valuation in the hundreds of millions of dollars in market capitalization. While many of these companies are now public, they might as well be private given the lack of liquidity — something to think about if being asked to participate in a new equity issue.

By comparison, there are some great technology companies out there that may also appear to be trading at a high multiple but are backstopped by double digit or higher annual recurring revenue growth. For example, we read about a Toronto based start-up that was recently sold for $50 million but saw its annual revenue increase from $2 million in 2015 up to nearly $30 million in 2018 prior to its sale. This is a 1.7 times trailing revenue multiple versus a 10 times forward revenue for the cannabis sector.

The other area of concern for us is the mortgage investment corp. market, which is being portrayed as a safe investment offering a high single-digit annual return to investors. The problem is that the underlying assets are often second or third mortgages that are therefore exposed to default risk, meaning investors could be risking a large portion of their capital for that promised 7 or 8 per cent annual return. This would be fine if one could actually do one’s due diligence on the mortgages, but the level of disclosure is often very limited in nature.

On the other hand, there are a number of Canadian blue-chip dividend-paying companies in the telecommunications, utilities or financial service sectors that are currently yielding more than five per cent, backstopped by strong balance sheets and high market liquidity. In that context, the risk-reward trade-off of a mortgage investment corp. may not look so appealing.

Ultimately, there is nothing wrong with taking on risk, but it is important to maximize the level of return potential when doing so. This means taking a step away from what others are doing and comparing a potential investment against other areas of the market.

Martin Pelletier, CFA is a Portfolio Manager and OCIO at TriVest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.