Anyone who drives a car knows intuitively that it can be dangerous. The risks of accidents are high if the basic rules are not adhered to.
These rules include learning how to drive, driving slowly in congested areas, ensuring your car is in good working order, paying attention to road signs and many other essential rules that act to safeguard you, and the public, against the risks involved in driving.
The majority of drivers can enjoy the enormous benefits of driving if they minimise the risks.
Investing is no different. But few people take the time to learn about investing, the associated risks and how to control or mitigate them.
The opportunities for learning, of course, are few and far between. We learn nothing in school or university about how to save and invest properly. The dangers of society not having at least a working knowledge of sound investing were exposed in the 2007-08 crisis.
Normally we might expect that we can outsource this task to the army of financial and/or investment advisers around the country.
In practice, however, most insurance brokers earn their pay not from the client for services rendered, but from the insurance companies for product sold. The majority of insurance brokers are, in fact, sellers, and have more in common with the stockbroking fraternity than they would like to admit.
There are two parts to investing in risk assets such as equities and property; we seek the higher returns that these assets have delivered in the past compared to bank deposits but we must take risk to get those returns.
But if an investor can’t identify at the outset which risks to avoid then it’s difficult to avoid them.
As we are all now aware following the events in 2008, learning how to save and invest is not a luxury in life, it is a crucial part of our daily lives, and we need to be more informed.
The disaster that has been wreaked on peoples’ savings and investments (and lives) in the last six years, and the personal traumas it has inflicted, need not have happened if people understood how to invest. And include buying a home as investing.
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 per cent annually above inflation over the long-term (before costs).
In contrast, bank deposits have delivered circa 1 per cent in excess of inflation over the long term.
Returns are generally much higher in equities (which include property) because businesses, in aggregate, earn a greater return on the capital used.
If this was not so, what businessman would bother taking the risk? If he is not rewarded for taking the risk he will put his money in bank deposits.
Understanding the risks
The best practical definition of risk that investors face is the threat 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 avoid this calamity can enable private investors to become more comfortable with risk assets. The risks of a permanent loss of capital can be categorised as follows:
The economic-specific risks
The stock-specific risks
The economic risks
Let’s look at the economic risks first. The economy is generally in one of four states; prosperity, recession, inflation or 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.
Deflation is the mortal enemy of 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.
Equity and property values in Japan remain 50 per cent below where they were in 1990, some 25 years later. That’s not much of an advertisement for investing in risk assets. Bonds and bank deposits offer protection against deflation, as they did in Japan through its deflationary years of 1992-2012.
As we can’t tell the future or predict which state the economy is likely to be in with any accuracy or consistency – 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 strategies) can mitigate the economic risks outlined above, and in particular the risks of deflation.
Returns from bank deposits, long-dated bonds, precious metals and hedge/absolute return strategies 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 such as this can lower risk, as it positions you to still generate inflation-plus returns while not being dependent on a decent economic backdrop.
The chart (above) highlights two points. The first is that an investment at the start of 1995 equally spread across the five major asset classes delivered a 6.1 per cent compound per annum return.
Take annual costs as, say, 1 per cent and your return was circa 5 per cent per annum, but still some 2 per cent per annum above the average rate of inflation over that period. The second point to make is that the returns were relatively smooth compared to general equities. Out of the 19 years involved from 1995-2013, you suffered a modest loss in only three years, with the worst annual loss coming in at 6 per cent in 2008.
In contrast, global equities delivered returns of 7.2 per cent compound per annum, or 6.2 per cent after costs, since 1995. But the ride was not as smooth. Between 1995 and 2013, global equities delivered negative returns in five out of the 19 years, with the deepest decline of -38 per cent occurring in 2008.
In defense of global equities, they were already overvalued in 1995 which most likely explains the fact that the subsequent returns have been below the average returns equities have delivered of over the long term of circa 9 per cent per annum compound.
While the world and his friend may continue to try, you should recognise that it is largely futile to try and forecast the occurrences of deflation, inflation and recession.
If you wish to mitigate these risks you must plan accordingly at the outset by spreading your money across the various asset classes.
However, also recognise that the global economy has tended to make progress over the long term, which favours equities and property. If equity returns are higher in the future than you have earned from a balanced asset portfolio, you should understand that this is the cost of taking less risk.
Next week, I will focus on the stock-specific risks in general equities for those whose glasses are generally half full, as opposed to half empty, and who are willing to commit more fully to equities (and property). Rory Gillen is author of 3 Steps to Investment Success and founder of GillenMarkets, Ireland's only subscription-based online investment newsletter www.gillenmarkets.com
