Rory Gillen
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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 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
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 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