I have reproduced here a post on a similar thread as a similar question was being raised and like many questions I see on askaboutmoney it is essentially looking for a forecast.
Well, let me let you all into a big secret - its impossible to forecast the future. Nobody can do it. I met with an analyst a few months back who told me "Bank of Ireland are yielding 10% and are on a P/E of less than 10 and have never cut their dividend at these prices they are a bargin"
If I had taken that "expert advice" when the shares were 6 Euro each, they are now 2.57 each!
Most people I meet seem to expect a financial adviser to somehow look into the future and make a forecast about which shares to buy or which fund manager or hot tip sheet is going to make them rich.
This is speculation not investment. Speculation is fine - as long as you understand that is what you are doing and don't confuse it with investment.
The problem with speculation is that you are just as likely to be wrong as you are to be right. For you to win, someone has to lose!
There is another way of looking at the world, based upon scientific empirical evidence.
The expected future return on any investment is a factor of its risk.
That is to say risk and return are related. Fact.
The single largest factor on the table is the cost of capital - that is why it is called capitalism.
Two factors have a proven scientific effect on the cost of capital for any company
1) The size of the company - a small company has a higher cost of capital than a big company and therefore investors expect and require a higher investment return to compensate them for the higher risk
2) The value of a company as measured by book to market. Ie the value of the company as measured by the accountants divided by the market value. A company with a high book to market value has a higher expected return than a company with a low book to market value.
So, on this basis, banks generally are moving further and further into this area they are becoming smaller companies with higher book to market values. The expected future return is therefore increasing relative to the market as a whole.
But here is the catch - which banks are going to make it through this? How many more are going to fail? If a bank is nationalised and you are a shareholder - you can get nothing at all. That is a big risk.
Another secret: Again nobody knows the future. Really, I know its hard to accept sometimes (especially if you are a stockbroker reading this) but really, nobody knows for sure 100%. So trying to guess which banks to buy has to be a mugs game. The expected return from speculation is zero less the cost of doing it.
This is proven time and time again with studies into mutual funds which show that on average a fund manager underperforms the market by their annual management charge. In practice you would have been better off with a monkey, a dart and a copy of a stock sheet. In fact you would on average have outperformed by around 1.5% because the monkey would have worked for bananas!
So, would I put money into a single Irish Bank. No, of course not. Far too much risk. A UK bank? Nope! What about the US no.
Would I buy the whole market across the world and hold as many companies as I possible can and simply catch the expected market rate of return over the long term (10 to 20 years) you bet I would.
Incidentlly for those of you who currently have no faith in capitalism over the last 20 years this expected return from the market has averaged 6% above a cash deposit.
Ah say the sceptics, the last 20 years are not representative. Good, I agree.
Over the last 100 and some years the worldwide equity risk premium is about 4% above cash. You take a risk, you expect to be rewarded. Your reward from buying (and holding) the market is, on average (with some big swings in there) about 4% above cash.
If you don't like the swings -take less risk. Put less into equities, or take risks you will be rewarded for.
Risks that I will be rewarded for would be if I tilt my portfolio slightly towards smaller companies and high book to market companies because I know over the long term that I will be systmatically rewarded for this specific form of risk. This is not a forecast it is an empirically proven scientific fact.
So would I exclude banks from my portfolio - no of course not. Would I speculate on bank stocks - no it's a mugs game.
Risk and return are related - equity investments are risky. Do we all see that clearly now?
Therefore I expect to be rewarded at the rate of the capital markets over the long term (at least 10 years+) but this requires me to capture the market return efficiently (ie the whole market, not an active investment fund, not market timing which can't be done, not stockpicking which can't be done, not putting 50% 75% or 100% of your portfolio into the ISEQ when it makes up only 1% of the entire planet)
To be a sucessful investor all you need is access to a low cost form of passive investment which captures the whole market return globally and allows you to tilt your portfolio into those areas where there is a proven reward for the risks taken.
There are some companies out there who seem to offer something approaching this - but there are lots of limitations which an investor needs to understand. ETFs have their shortcomings, Tracker funds have their shortcomings.
For example: small companies are typically illiquid with huge spreads - ie it can sometimes cost you 6% to get in. The premium from buying smaller companies is on average about 4% above large companies. So trading costs are critical here or you will wipe out the higher expected return that is on the table.
Recent events have shown the markets to be a risky place for the unaware. There is no such thing as a free lunch. Risk and return go hand in hand. If you are making 20%pa on the way up - you have to expect a 40% or 50% fall. Why would it be any other way?
“The idea that any single individual without extra
information or extra market power can beat the
market is extraordinarily unlikely. Yet the market
is full of people who think they can do it and full of
other people who believe them….Why do people
believe they can do the impossible? And why do
other people believe them?
Daniel H Kahnemann, 2002 Nobel Laureate in
Economics.