When we look at the possibility of investing, one of the first issues we come across is talk of ‘risk’. Unlike savings accounts, the value of money invested in stocks and shares is volatile. It could be worth more today than it was yesterday. But then worth less tomorrow than it is today.
And vice versa.
Which is all very well, but why?
Why does the value of an investment vary from day to day? What enemies should you be looking out for? And what you can you do to ward them off before they start to bite?
The answer is not quite as straightforward as we might like. The reasons for the ups and downs are many and varied. But fear not. Your enemy, when recognised and prepared for, can be won over and turned into a friend.
1. Stock Picking: Specific Risk
If you have ever heard of Lehman Brothers or Enron, you will probably understand specific risk. Because this is the risk that that a specific company will outperform (or underperform) its peers.
Stock picking fires our imagination but specific risk is amongst the most difficult to consistently predict. Lehman Brothers, for example, had been riding high collating and distributing what everyone at the time considered to be lucrative bundles of debt.
Right up until those debts defaulted. Enron had appeared to be performing similarly well but was actually in the process of falling victim to massive fraud. A fraud orchestrated by its own Chief Financial Officer and hidden from everyone but a core inner circle of its accountants.
Both companies ended up filing for bankruptcy, with little or no return for any of their unfortunate shareholders.
That’s the downside, of course. Such high-profile issues are rare. And specific risk is not all about negative performance.
A company can also outperform its peers. As the shareholders who have held Amazon for the last 3 to 5 years will tell you. Or those who have managed to hold onto Apple for most of the past ten years, albeit with some blips along the way.
The thing is, companies which experience massive growth are as rare as huge bankruptcies. To dwell on this aspect of investment for too long would be an error. Because very few people can consistently pick the winners. Or avoid losers. Most people would be better off buying a basket of shares, some of which will be good. And some of which may not be.
Because there are far greater forces at work in stock markets than the impact of specific risks. Forces that will have far greater influence over whether you are successful in meeting your goals and which you can do more to mitigate. Starting with…
2. Market Risks
It might sound like a short cut to riches, but even picking the best company in the world won’t save you when markets go down. When US markets have fallen during the past 10 years, even Apple and Amazon have been affected to some extent.
Driven by a number of factors – recession, political issues, interest rates, currency fluctuations, maybe even terrorist attacks – there is only one way to protect yourself against market risk. And that is to invest in lots of different markets.
Do not put all your eggs in one basket. Spread your money around. Not just across the world but across different asset classes as well.
3. Inflation Risk
You probably won’t remember this but back in January 1978, Mull of Kintyre was top of the charts. And a pint of milk cost just 13p*.
As I write today, Drake has the number one spot, and milk is 45p*.
The reason? I can’t really comment on Drake. But for the price of milk? It’s inflation.
Inflation is a measure of the rate at which prices rise. And as prices rise, what you can buy with your money reduces. Which means, if you put your money under the mattress, you may consider that made it secure in absolute terms – but in relative terms, it would actually be falling in value every year.
In our 1978 example, £1 would then have bought you over 7.5 pints of milk. Today it will buy you only just over two. £1 today, then, is worth less than 30p was worth back in 1978. On this milk scale, our buying power has fallen to less than a third of what it was.
The aim for any investment you make then is to achieve a rate of growth on your money that is above the rate of inflation.
So that your spending power is at least retained. So that you end up with enough to buy at least as much as you can now and, hopefully, if your investment does well, enough growth to allow you to buy even more.
4. Legislative Risk
Depending on how old you are, the Pensions Freedoms that were introduced in 2015 might have passed you by almost unnoticed. If you are over the age of about 45 or 50, however, they were a revolution.
In one short phrase, the Chancellor at the time – George Osbourne – removed virtually all limitations on how money could be spent in retirement.
No longer wedded to guaranteed annuities, he allowed us all to start making decisions about our income, with more flexibility than ever before.
This article is not about the relative merits of that change, however. What it is about is the impact those changes had on people entering the final years of saving for retirement.
From the position where they thought their options were all mapped out for them, they moved to a position where they had to start making decisions. And live with the results of those decisions.
Governments love to meddle with long held traditions and approaches. They are prone to changing their minds – and/or changing the rules of previous Governments. It’s a fact of life – and not just for our money.
The key, therefore, is to keep your investment-related eyes peeled, monitor your progress regularly, watch out for unexpected developments – and keep your options open for as long as you can.
One of the big talking points in investment right now is fees. Because what might be considered a very small difference in annual charges – perhaps just 1% – can actually have a massive impact on what you ultimately get back.
So you need to be sure that the payback you are getting is real. And worthwhile.
The thing is, not very many people are able to make consistently good investment decisions. Not even the professionals. Outperforming is a much rarer occurrence than you might have been led to believe. And high fees just make that task even harder.
That is why fees can easily become your enemy.
If you are just starting out in investment, there is very little wrong with a low-cost, tracker fund. They are simple, they back every horse in the race. They help you learn about how markets work as you drip feed in some regular savings. And they cost as little as 15p-30p per £100.
(Note: if you have existing investments, make sure you check this year’s statements. There will be more information on the impact of charges than you will have seen before. So keep an eye out. The reality might take you by surprise.)
Yes, you. You can – I can – we can all be our own worst enemies when it comes to investment. Well, given my job, I’d certainly hope I’m not, but you get the idea.
The things is, we all feel more confident when markets are riding high. And we all feel more fearful when markets start to fall. Which means we commit the deadliest of investment sins: buying when markets are high and selling when they have fallen.
Consider if you will, the last few months’ hype around Bitcoin. It is a perfect example of people getting carried away by hype, by the lure of huge growth. Then following the herd without thinking.
Now, I’m not suggesting for a minute that I know what will happen to Bitcoin next. But there has been a lot of hard earned money put in and I really don’t believe most people fully understand what it is.
As Warren Buffet suggested, “The markets are a device for transferring money from the impatient to the patient.” So, don’t be impatient for results.
Take your time, be consistent, avoid hype and only take the plunge when you know what you are plunging into.
This article is part of our Investing Series, to be followed by more interesting facts, smart practices, advice and suggestions. Why not join us so you do not miss any post in this series to learn more on a subject that has a much better performance yield than the lottery?
*Source: National Office of Statistics, RPI measures: the average price of milk. Jan 1978 vs Jan 2018.
Over to You!
Have you come a cropper when investing? Or have you vanquished your investment enemies to come out on top? Share with us here – we’d love to hear your experiences!
Post in this series
- The Enemies of Your Investments (And How Turn Them to Friends) - March 20, 2018
- How Do I Start Investing (And Stay Invested)? - August 1, 2017
- Finding Advice – 7 Questions to Ask When Choosing a Financial Advisor - June 6, 2017