to be a good investor you need the time, energy and patience/discipline to make it work; for many of us we simply don’t have that
Every day we take risk without considering the consequences.
Interestingly almost every action we take carries risk; the list below from besthealthdegrees.com considers the chances of fatality from some normal activities (as well as some less so).
1 in 300 million of death from a shark attack
1 in 250 million of death from a falling coconut
1 in 100 million of death from table and computer games
1 in 2.3 million of death from falling from a ladder
1 in 2 million of death from falling out of bed
1 in 1 million of death from swimming or running
1 in 140,845 of death from cycling
1 in 100,000 of death from a dance party
The chances of being in a place where we are attacked by sharks is low compared to being in a bed. Knowing that we have a 1 in 2 million chance of dying by falling out of bed might make us consider the risk of getting into it! (The actual number of deaths in the UK is just 20 each year).
The question is how do we approach this; most people would say that they don’t even think about it. If we take an activity like cycling, we rarely consider the risks. We might buy a helmet, lights and reflective clothing because we want to feel safer but there are many who don’t. If we take the latter group subconsciously they might consider the risk but clearly, they discount this; and yet the probability is that they are more likely to be injured than the first group of people.
Interestingly when we come to talk about investing all rational thinking goes and we can be in danger of thinking that it is risky. This is because we feel there is a chance that we can lose money. This fear is heightened by events like Black Monday (1987), Tech Bubble (2000), Credit Crunch (2008) and Eurozone Crisis (2011).
In this blog, I want to explore whether this is rational thinking and whether in fact there is no more risk in investing than anything else we do.
What is risk when it comes to investing
In simple terms, it is about losing money.
It is, however, a little more complicated than that because what is losing money? Take two people with £100 invested in the same company over a ten-year period. The first goes away for ten years to a place where there is no access to information. When they come back they have £150.
The second person stays at home and checks their investments every day. Five years into the investment the value is just £50. If the second person sold the investment in year 5 they would have lost £50, but by holding onto to it for another 5 years they made £50 on top of their original investment.
This highlights a modern-day problem; connectivity. Being able to see the value of our investments can be a curse because it can give us a perception that we have lost money. One of the reasons why people lose money is because fear leads to irrational decision making. It is very hard to look at a 50% paper loss and think it will come good. At that point it is easy to lose sight of the goals and turn the paper loss into a real loss.
Often when a market falls, the following year it strongly rebounds. 1988, 2009 and 2012 are three such examples. To have held firm would have meant making a small profit over those periods. Selling out would likely have taken years to replace the losses.
And yet with all the evidence this is what we can fall into the trap of doing. Often the only “safe” option is cash. With cash now at near zero, this creates a further challenge.
If cash had no interest and inflation was 2% then each year, in real terms the value is going down; with £100 to achieve the same purchasing power you would need £102 at the end of year one (basically this is saying, for example, if a television was £100, with inflation at 2% that same television would be £102). By year 10 you would need £110.40. Effectively your money is worth less than its original value.
So even opting for cash brings challenges, and the possibility of negative real returns. The next trap is to wait for markets to recover and then re-invest because getting the time right is very difficult and many fail to time the market correctly.
In summary, risk (the loss of money) only happens when we sell our investments when they are valued at a lower price than we bought them. Often holding onto investments should ensure long term returns if we follow some straightforward rules.
Taking on risk
The risk we take with our money should reflect what we plan to do with it. Money that we need over the next twelve months will be treated differently to that which we need in 20 + years’ time.
If we know we need the money for a holiday within the next 12 months, then we are more likely to hold the money in cash even if we receive no interest on it. We weigh up that retaining the capital is more important than any potential growth.
However, if we are investing for retirement in 20 years’ time then we are going to look to maximise returns. It is worth adding that when we reach retirement we may choose to receive the income from our investments which could mean a further 20 plus years of investing is needed to sustain income. In all probability investing in cash over this time frame would be crazy.
When we look to invest, there are many factors which determine the level of risk we take, below are some examples:
1. Over-exposure and non-diversification – on 30 December 1999 the FTSE 100 stood at 6,950.60. If the only holding was invested in the FTSE 100 at that point, then the returns would effectively be zero (negative when inflation is factored in).
There are many factors which impact companies and countries. Choosing to invest in one company or country will heighten the risk. To diversify across companies and countries will reduce that risk.
The easiest way to achieve this is through investment funds which pool assets and invest in all markets including Europe, the US, Asia, Emerging Markets, UK etc. By doing this, investors can also select funds which invest in large or small companies. This reduces stock specific exposure which can increase risk overall, so by buying into “funds” rather “shares” (funds hold lots of different shares within them) you are maintaining your access to the companies you want to buy into but you are spreading your risk by pooling your investment with that of many other investors.
In summary, it reduces the risk of loss over the short term, and provides the potential for long term growth.
2. Asset allocation – if we invest in equities, this will carry more risk than other asset classes as a standalone investment, but on the flip side equities are proven to deliver the highest levels of return. With diversification, it is not just about countries and companies but also assets. Bonds are fixed term loans by companies or governments which are seen as lower risk and less volatile than equities.
The general rule has been that equities go up when economies do better and bonds do better when economies go down. Their low correlation to one another is why they make a perfect pair in a portfolio, because the growth in one asset usually offsets losses in another.
Many investors hold a percentage within their portfolios to counter the volatility of equities, the level held depends on someone’s view. If someone is cautious they might have 60% in bonds and 40% in equities, but someone who is adventurous might have 20% in bonds and 80% in equities.
There is a third option which is “alternatives” which again can behave differently to both bonds and equities, such as infrastructure and physical property. A cautious investor might have 40% in bonds, 20% in alternatives and 40% in equities, and an adventurous investor 20% in bonds and alternatives and 80% in equities.
In summary before investing it is worth considering how we mix different asset classes to lessen or increase the exposure to risk that we are prepared to take.
3. Investing on “tips” – whether it is a friend, or a journalist investing on “tips” can be a dangerous pastime. Before investing for our clients, we spend hours researching potential and existing investments. We even take time to meet the fund managers to get an understanding of how they approach investing. This is important because we can identify times when perhaps they might underperform and crucially cross check what they are saying matches the marketing hype. Only when we are happy with the outcome of our research would we consider investing.
4. Rebalancing – some say “long term investment is short term trade gone bad”. There is some truth in this but equally if the research is there, and fundamentally nothing has changed with the management then there shouldn’t be a reason to sell an investment. It sounds counter-intuitive but rebalancing the investments to the same percentage each year installs a discipline which takes profits from the winners and buys more from the losers. It is also a time to review any holdings whether good or bad and challenge whether we should still be investing in them.
The point with rebalancing is that we are not trying to predict the future, but to adopt a discipline in our approach to investing which is proven to grow assets over time.
5. Leveraging too much – this is putting a large bet on one investment which you can’t afford to lose.
There is truth in the statement “only invest what you can afford to lose”. When we come to investing, we wouldn’t look to back one investment but spread across a number of different ones. We also look closely at funds, because a fund which has perhaps a 10% weighting in one or two stocks can carry considerable risk should the fund manager’s investments go against him. This type of weighting may affect the amounts we invest.
6. Daily trading – one of the easiest ways to lose money is through day trading; this is watching a stock, buying “cheap” and then selling at a profit. This requires a considerable amount of time, research and patience. Very few get this right. Our view is to find good long term investments which can grow wealth slowly over time, rather than trying to chase short term bets.
When we consider the risks of cycling against that of investing there are similarities. We can reduce the risk of fatality on a bike with some simple things; use lights, wear a helmet, and reflective clothes. Likewise, when we come to invest money it doesn’t have to be risky. We need to consider what the money is for, the likely timeframe of investment and then we can build investments that match that requirement. But whether it is buying the right things for a bike or for investments it comes down to research and maintenance.
Research is great but things change over a 12-month period and therefore maintenance is crucial, if we don’t maintain our bike then it is likely that parts will fail within 12 months. The same applies with investments; continually monitoring them and making sure they are on track and rebalancing at a set time is crucial.
Conclusion – a life less complicated
We started by saying that each day we take risk. I find it unnerving that there is a chance that I could fall out of bed and die. Is there anything I can do about it, no! Therefore, going to bed is a risk I am prepared to take.
When it comes to investing, there are factors beyond our control, we can’t directly influence politics, or financial crises but we can put together investments which match our goals. Ultimately, investing is as risky as we want it to be. If I had a bill of £10,000 to pay in six months, then to invest in shares would be extremely risky and I would have to accept the potential for loss. On the reverse if I want to protect it, holding in cash achieves that aim but I have to accept there will either zero or minimal return.
It’s worth adding this, research is the crucial part of investing and speaking to a friend who self manages his investments I asked him how he approached it. He explained he was a contrarian investor, looking for long term opportunities which were still cheap. I asked him how much time he spends monitoring his investments and he explained that he checks them every day as well as constantly researching ideas.
The point being that that to be a good investor you need the time, energy and patience/discipline to make it work; for many of us we simply don’t have that. If we don’t have the time, then this can increase the risk.
In summary investing doesn’t have to be risky; we can choose to make it so by the decisions we make and if we can’t dedicate the time to this, then employing someone to do this for us has to be a good investment in itself.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.