# Understanding the Risks in Investing



## Rory Gillen (22 Jun 2014)

There are two parts to investing: we seek the returns but we must take risk to get those returns. When looking back on the dreadful year that was 2008 (for investors, at least), the one question I often posed for myself was: did you understand what risk really was? For if we can't identify what risks we wish to avoid at the outset then it's hard to avoid them. Understanding what 'risk' really is also helps us stay calm in more difficult market conditions.

I read a lot and often find that others have explained things in a way I never previously thought of, and their explanations assist in making it easier to follow seemingly complex issues. 
Hence, leaning on the many excellent books I have read myself this post is an educational-style piece which may be a departure from the norm for this website but hopefully it can make 'understanding the risks in investing' easier to follow for many others who have an interest in the area.

_Investing in Risk Assets_
Risk assets, which include equities, property, precious metals, long-dated bonds and hedge/absolute return strategies, have mostly delivered better than bank deposit returns over the long-term. For example, equities in the developed markets have delivered returns of circa 5-6% above inflation annually over the long-term (before costs). In contrast, bank deposits have delivered circa 1% in excess of inflation over the long-term. Herein lies the reason for taking the risk; the returns are generally higher.

_Understanding the Risks_
The most important risk investors have, and rightly have, is the risk of a permanent loss of capital (first defined as such by Ben Graham in his book _The Intelligent Investor_). However, fully understanding what can lead to a permanent loss of capital and how one can control this threat, and avoid it, enables one to become more comfortable with risk assets.

The risks of a permanent loss of capital can be sub-divided as follows:


The economic-specific risks
The stock-specific risks
_The Economic Risks: _

The economy is generally in one of four states:

1. Prosperity
2. Recession
3. Inflation
4. Deflation

Equities and property need economic prosperity to deliver the returns. Recessions and inflation tend to hurt equities and property in the short-term but this simply reflects the business cycle, and rarely leads to a permanent loss of capital. Bank deposits are good to own when recession hits (often because interest rates are rising at that time) and gold often performs best when an inflationary outbreak occurs (as gold is a proven inflation hedge). That said, good quality equities, particularly those with good pricing power, almost always recover from recessions, and in time adjust for inflation. So, owning bank deposits and precious metals to cover the risks of recessions and inflation is a choice but not a necessity as long as one is investing for the medium- to long-term. So long as your investment time horizon is 5-10 years, a good quality equity portfolio should still deliver inflation-beating returns, assuming what you own was not overvalued at the outset.

Deflation is the mortal enemy for equities and property, as it can result in negative returns from equities and property assets over an extended period. Japan is a modern-day example of an economy that was mired in deflation for many years, which led to significant and persistent declines in both local equity and property prices. Bonds and bank deposits offer protection against deflation, as they did in Japan through its deflationary years of 1992-2012. Over that same deflationary period in Japan, there was no hiding place for equity or property investors in Japan.

As we can't tell the future or predict which state the economy is likely to be in (although many persist in trying), spreading your investments across the five main asset classes (equities, bank deposits, long-dated government bonds, gold and hedge/absolute return funds) can mitigate the economic risks outlined above. Returns from bank deposits, long-dated bonds, gold and hedge/absolute return funds are not dependent on the state of the underlying economy and, in that regard, their returns are uncorrelated to equities and property and the economy. For this reason, owning a spread of assets like this lowers risk as it allows you to generate inflation-beating returns while not being dependent on a decent economic backdrop.

But as the global economy has tended to prosper over the long-term, which has favoured equities and property, spreading monies across the asset classes is a choice to be made rather than a necessity. As equities offer the best potential returns – on the assumption they are not overvalued at the outset - an investor who spreads monies across the asset classes should expect a lower return over time.

_Stock-specific Risks_: 

Buying equities does not guarantee a good outcome, even when equities in general perform well, if an investor does not control the stock-specific risks which include:

· *the business risks* – the risks that the company will not be earnings in five to ten years what it is earning today. This risk is particularly hard to gauge. It demands an understanding of different industries, competitive advantages and many other business attributes. For non-professional investors, this risk is best countered by diversifying.

· *the financial risks* – the risks that the company has inappropriate financing or debt levels which can undermine shareholder value. Again, this risk is not easy to asses for non-professional investors as different industries can accommodate different levels of debt for a given cash flow stream.

· *the valuation risks* – the risks of overpaying for even a good company to the extent that you compromise the long-term returns available from the shares.

If you can’t identify these company-specific risks then investing through funds is a viable alternative. Diversification through funds covers both the business and financial risks. It does not, however, cover valuation risk. Here, an ability to value an asset is important. But again, risk assets can't be valued in isolation as the swing in interest rates can have a major impact. Low or declining interest rates can make equities look better value, and high or rising interest rates can make them look more expensive.

If the above represents a fair analogy of what investment risk really is, then volatility in markets can be understood for what it is: not risk as such but just part and parcel of the interaction between investors. In that regard, lower markets are more likely to be welcomed by the investor who understands what risk really is. 

For those who attempt (or prefer) to trade markets, risk is volatility, as they are trying to get returns over a shorter time horizon. The trouble with this is that trading does not give you the time to benefit from the natural appreciation of markets over time. In the short-term, trading is largely a zero-sum game with one person's gain being another person's loss. But as the markets tend to rise over time, just like property, all investors can make a return longer term. The markets are not a zero-sum game in the long-term; they rise to reflect the growth in economic activity which fuels rising sales, profits and cash flows for business in general.


*Rory Gillen
Founder, GillenMarkets.com*


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## dub_nerd (23 Jun 2014)

Thanks Rory, very useful summary. You mentioned valuation risk several times. How does the novice investor assess that? Not looking for a tome, or free advice, but just what are the major parameters?

Are there times when entire markets, and not just individual stocks, are overvalued? Some people seem to think we are in that situation now, with government stimulus policies being the main culprit. Is there a case to be made for waiting until some sort of reset before diving in, even if that means waiting several years?


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## Steven Barrett (23 Jun 2014)

Good post Rory. 

The greater people's understanding of risk the better. We all have to learn from what happened at the credit crunch crash. 

People have to have realistic expectations at the beginning and understand that potential for greater returns also comes the potential for greater losses.

If people are invested in portfolios they fell comfortable with at the outset, you reduce the rush to cash when there is a market crash and the investor gets hit again. 


Steven
www.bluewaterfp.ie


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## Rory Gillen (26 Jun 2014)

dub_nerd said:


> Thanks Rory, very useful summary. You mentioned valuation risk several times. How does the novice investor assess that? Not looking for a tome, or free advice, but just what are the major parameters?
> 
> Are there times when entire markets, and not just individual stocks, are overvalued? Some people seem to think we are in that situation now, with government stimulus policies being the main culprit. Is there a case to be made for waiting until some sort of reset before diving in, even if that means waiting several years?


 
I did a 'Featured Article' on my website after I published the book and our Featured Articles are accessible to non-members of the GillenMarkets website. They form part of our marketing for new members. Here is a link to that article. 

[broken link removed]

We deal with valuation of assets in our weekly investment bulletin to members as valuation is key to what stocks/funds/assets we recommend for purchase.

*Rory Gillen*


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## cremeegg (27 Jun 2014)

Great post Rory.

You point out that equities in the long term return more than other investment assets. That seems to be generally recognised. 

You say that for an investor with a long term perspective risk is not the same as volatility. This is not the general understanding of risk. Most models equate volatility of quarterly returns with risk. I agree with you that short term volatility should not be considered risk for a long term investor. 

However the inevitable conclusion to be drawn from these two points is that a broad basket if equities is less risky that other assets. And so equities do not deserve a risk premium 

Alister Ross Goobey snr working at the British Post Office pension fund recognised this in the 1950s and as a consequence of his work the actual equity risk premium fell. 

As there is still some premium return for equities the lesson is. Here is a free lunch. Invest in equities


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## monagt (27 Jun 2014)

http://www.businessinsider.com/27-things-every-investor-needs-to-know-2014-6#stocks-have-outperformed-every-other-asset-in-the-long-run-in-shorter-specific-periods-however-this-can-vary-meanwhile-cash-is-in-fact-not-king-as-it-struggles-to-keep-pace-with-inflation-3

This is FYI, if against rules, please remove, but I thought it would be of interest to the ongoing conversation.

Also, good post from Rory.....and contribution from Cremegg.....thx


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## dub_nerd (28 Jun 2014)

monagt said:


> http://www.businessinsider.com/27-t...as-it-struggles-to-keep-pace-with-inflation-3
> 
> This is FYI, if against rules, please remove, but I thought it would be of interest to the ongoing conversation.
> 
> Also, good post from Rory.....and contribution from Cremegg.....thx


 
That graph looks fine if you focus on the trend line through the equities. If you look closer at the wiggly line, it seems to me there are three periods in just the last hundred years where, if you bought at the wrong time, you'd be waiting more or less twenty years for stocks to regain their values. I'm sure the trend line is cold comfort to those people. With reasons to believe that stock (and most asset) prices are overvalued at present, isn't there room for caution?


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## Jim2007 (28 Jun 2014)

dub_nerd said:


> Thanks Rory, very useful summary. You mentioned valuation risk several times. How does the novice investor assess that? Not looking for a tome, or free advice, but just what are the major parameters?



There are many different approaches to valuation, but in reality very few investors or advisors for that matter are capable of coming up with a reasonable valuation for a company.  And for that reason alone, it is best for most investors to simply buy the index (EFT) rather than invest in individual stocks.

If you really do want to invest in individual stocks then I would suggest a different approach, one promoted by the NAIC in the USA called SSG (Stock Selection Guide).  The idea is that while most investors have no problem identifying good companies to invest in, they tend to over pay for the stock and thus fail to obtain a good return.  So the tool tries to ensure that investors do not over pay for the stocks they invest in.  If you do a google search you should find plenty of documentation on the approach plus a few xl sheets that can be used to implement it.  



dub_nerd said:


> Are there times when entire markets, and not just individual stocks, are overvalued? Some people seem to think we are in that situation now, with government stimulus policies being the main culprit. Is there a case to be made for waiting until some sort of reset before diving in, even if that means waiting several years?



At any given time you will find people in both camps, but it really should not matter to you as an investor because you are in it for the long term and if you are using a tool such as the SSG to price stocks, so you should not be over paying in any case.  By the same token if you are investing in the index, you should be 'dollar cost averaging', which means the impact should be minimal in the long run. 

Another point to keep in mind is that you should not be investing in the Irish stock exchange to start with!  Apart for a couple of stocks, most of the stuff listed on the Irish stock exchange should be considered micro caps and not something the average investor should concern themselves with.  You should have at least a Euroland or EU investment horizon. 



dub_nerd said:


> That graph looks fine if you focus on the trend line through the equities. If you look closer at the wiggly line, it seems to me there are three periods in just the last hundred years where, if you bought at the wrong time, you'd be waiting more or less twenty years for stocks to regain their values. I'm sure the trend line is cold comfort to those people. With reasons to believe that stock (and most asset) prices are overvalued at present, isn't there room for caution?



Well as I have said up above, if you have been buying good stocks at reasonable prices or dollar cost averaging over your investing live, then these dips will have had only minimal impact on your investments.


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## monagt (28 Jun 2014)

> You should have at least a Euroland or EU investment horizon.



UK included?


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## Jim2007 (28 Jun 2014)

monagt said:


> UK included?



Well the UK was still in the EU last time I looked!


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## dub_nerd (30 Jun 2014)

Jim2007 said:


> Well as I have said up above, if you have been buying good stocks at reasonable prices or dollar cost averaging over your investing live, then these dips will have had only minimal impact on your investments.


Ok, so if you _haven't_ -- if, instead, you are like me, with a lot of cash and considering serious equity investments for the first time, then this may well be a very bad time to jump.

Even many central banks are suggesting the markets are out of line with the economy, due to monetary easing. If central banks are talking about a "puzzling disconnect between the markets' buoyancy and underlying economic developments globally", one has to assume there's serious risk out there.

http://www.independent.ie/business/...p-with-global-economic-recovery-30393540.html


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## monagt (30 Jun 2014)

> Well the UK was still in the EU last time I looked! Jim2000



Oops! ¯\_(ツ)_/¯

I suppose I was thinking of adding currency risks (in relation to investment horizon) into the equation and your thoughts on that.


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## Jim2007 (30 Jun 2014)

dub_nerd said:


> Ok, so if you _haven't_ -- if, instead, you are like me, with a lot of cash and considering serious equity investments for the first time, then this may well be a very bad time to jump.



OK lets start by rolling the discussion back a bit, have you already determined your asset allocation?  Are you already fully invested in those asset classes that are reasonably or undervalued?  If not then those are the things you can do first.

Next for the equities, assuming you are going for ETFs, when introducing a large some of money is best to also 'dollar cost average' if over a period of 6 to 12 months.

One thing that does concern me is your approach to market risk, you can't time the market and I fear your attitude to the current market situation could well have you selling on dips and buying on surges, which is a very common reason why investors do not do as well as expected.  For this reason I would suggest you consider investing in large cap indexes as they tend to be less volatile and still offer reasonable value.  Something like the MSCI or STOXX.


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