by Alexandre Riley
Headline news about a British woman involved in a Shark Attack on the BBC website this week got me thinking about investment risk. The media loves a good shark attack story because it feeds into everyone’s natural fears, even though the chances of it happening are virtually indistinguishable from zero, with the International Shark Attack File (ISAF) reporting just 4 shark attack fatalities worldwide during 2016. Stories like these actually help us to make better financial decisions because it shows us that by understanding the probabilities involved, the fear of financial loss can be overcome, enabling investors to plan better to meet their long-term goals.
We’ve all wondered what lies beneath when paddling out too far whilst on a summer holiday but we tell ourselves not to be silly because in these instances we already know that the chances of an incident are either impossible or insignificantly low. In fact, even getting to our destination incurs a risk that many people overplay, which is the fear of being involved in a plane crash. I’d be lying if I didn’t confess that landing safely always brings me a certain sense of relief but in reality, I already know that the anxiety of flying is irrational, it’s statistically one of the safest ways to travel and the fear of death is not supported by the evidence. In fact the ‘Am I Going Down’ iPhone app calculates that there is a 1 in 5.4 million chance of going down on a Virgin Atlantic flight from Heathrow to New York. The app then estimates that you’d have to take the same flight every day for 14,716 years before it statistically plummets into the ocean!
So these are simple examples of how the anxiety of a risk looms larger in our minds than the actual risk itself and in both the case of shark attacks and flying, most (but not all) people are able to control their anxiety because they fully understand the small probability of it happening, rather than caving into their brains worst case scenario.
Now, this is where for some reason that logical process breaks down when it comes to investing. Investing for a future gain does indeed come with its own set of risks, which the largest for most of us is the risk of a capital loss. But rather than spending some time to appreciate what that risk is statistically and how it can be managed to reach an acceptable risk/return balance, many choose to ignore the statistics, instead accepting broad media scare stories and end up not investing at all, or worrying excessively when we do, or on the flip side of that unknowingly taking on more risk than they actually need or understand.
Investment risk comes in many forms whether it be the loss of value of your cash savings due to the effects of inflation or the complete loss of capital due to the failure of a single company in which you hold shares. But these are two very extreme ends of the spectrum and in reality, people like you and me choose to invest somewhere in between these two ends. The risk of a loss can be managed to meet your emotional ability to withstand it, to meet your personal financial circumstances and to match your financial goals, whereas by choosing not to take any investment risk at all (or not enough risk) you avoid the fear and possibility of a loss but you also resign yourself to low returns that are unlikely to match your long-term objectives. Cash interest rates and lower risk returns just cannot support long-term financial goals if inflation is at a higher rate, so unless you’re already fabulously wealthy, you probably need your savings to grow substantially higher than the rate of inflation if you want to meet your future financial demands.
So how can investment risk be better understood and managed to meet financial goals? Well, once you have decided that you are financially comfortable enough to make an investment there are a number of different techniques that can help reduce the risk of a significant loss. However, the two simplest reducers of risk are the ability to invest for a long time and the use of diversification to avoid the possibility of all of your investments heading in the wrong direction at the same time.
Time – The fluctuating value of stock market investments is a natural part of the investment journey and you must accept from day one the fact that periods of loss are expected, inevitable and perfectly normal. It is the ability to string together enough periods of loss and gain over time which allows us to achieve an acceptable average return over that period to meet our financial objectives. However, we often overestimate the impact of losses (just as we overestimate the chance of a shark attack or plane crash) based on media coverage or recent history and we quit at the first sign of any trouble. Only by having enough time and staying the course can we ensure that the chance of experiencing a loss is reduced, so the earlier you start to invest and the longer you hold on, the better.
The chart below shows over 100 years of US stock market return history (in dollars) up to the end of 2016 as represented by the S&P 500 Index of large US company shares.
Source: thinknewfound.com Past performance is not a guarantee of future returns.
There have been some pretty nasty losses during that period, but when viewed next to the preceding and subsequent gains, there is a lot more to be positive about than negative. In fact even if an investor had unluckily placed all of their money in only the US stock market at the worst possible time in recent history (Sept. 2007, right before the Financial Crisis) then even walking straight into an immediate and significant loss, the market would still have gone on to recover over the following years to the extent that the average return over the whole period inclusive of the of initial loss, created a gain of over 6.50% annually. Now, history doesn’t always repeat itself and past performance is not a guide to the future but if your investment goal is many years into the future, such as retirement, then the chance of making a loss is reduced over time and an average return in excess of inflation could help you to secure a better financial future.
Having time is great but in reality, most people just can’t sleep at night with the threat of a large loss, however short lived. Seeing a £250,000 portfolio cut in half understandably brings out the worst decision making in people, which is why it is very rare that investments are arranged in this way, so the second basic risk management tool is diversification.
Diversification – The old adage ‘Don’t put all your eggs in one basket’ certainly rings true when it comes to investment and the management of risk. Faced with a potential loss of up to 50% or more even when investments are made into a broad spread of shares via a fund or index, many people fold, which is completely the wrong thing to do in those circumstances. Diversification, therefore, helps to manage the expected maximum loss (but it also limits the gain) to within a range of returns that an investor may feel comfortable with or may feel is suitable to meet their financial goal.
By investing in a fund, which can invest in hundreds of shares instead of ‘trading’ a handful of personally chosen shares, you already reduce risk because the poor performance of one share will not materially impact your overall returns.
By taking this a step further and investing in two or more different ‘assets’ that react independently of each other, it is possible to reduce the risk of loss further. The asset traditionally held by investors to diversify the risk of shares are ‘bonds’. Shares provide a participation in the financial fortunes of a company whereas the lowest risk bonds are loans to the Government who agree to pay an ‘interest’ on the loan in return for having access to your money for a period of time. Most Governments are considered secure, and US and UK Governments have met all interest payments and repaid their loans on time, so investment in them is generally safe. Diversified bond funds are also available and when stock markets perform poorly it is not uncommon for bonds to perform well relative to shares as investors switch to safer investments.
To understand diversification better, as a simple example, a man selling ice cream during the British summer will make many sales on a sunny day and almost none on a rainy day so the weather is a big risk for him. However, if he sells both ice cream and umbrellas he’d make sales of each on sunny, rainy and unsettled days.
As a real example of asset class diversification, the chart below shows the growth of $100,000 invested in either the US stock market (S&P 500), the aggregate US bond market (S&P US Treasury) and a diversified portfolio holding 50% of each, between 30th September 2007, the onset of the financial crisis, and 31st December 2016.
Source: Morningstar Adviser Workstation. Past Performance is not a guarantee of future returns
You can see that where the US stock market (green) immediately lost 50% of its value during the financial crisis, the Bond market (orange) lost virtually nothing and a portfolio consisting of both (blue) performed somewhere in between. Over time, the stock market did recover and eventually overtook both the bond and the diversified portfolio but with the higher risk of the initial loss and the continued threat of future losses at any time.
Therefore diversification can be used to manage the overall risk of loss in a portfolio and the risk can potentially be managed further by investing in additional assets such as property and commodities, and by investing globally such as in the UK, Europe and Emerging Markets for example. But the fundamental principle of mixing the overall equity/bond allocation anywhere from zero to 100% is the main determinant of a portfolio’s expected risk of loss, and return.
So in summary, investment risk comes in many forms but to most people, it’s the fear of suffering a capital loss. Taking a little time to appreciate the probabilities of something bad happening instead of accepting the anxiety generally driven by the imagination, is the first step to creating long-term financial security with your disposable income or capital. For most people, the fear of a shark attack or a plane crash will be overcome by the wish to enjoy a swim in the sea or get to an overseas destination and together with a rational understanding of the low probabilities of a negative outcome, most people make the decision to proceed. That process should be applied to investment planning and the risks should be better understood by investors if they wish to improve their future financial security and meet their long-term financial goals.