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What Have Driving a Car and Investing in Common: More Than You Think!

There are two parts to investing in risk assets like 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. When looking back on the dreadful year that was 2008 (for investors, at least), the one question I posed for myself was: did you understand what risk really was? For if an investor can't identify at the outset what risks he wishes to avoid then it's hard for him to avoid them.

Drivers intuitively know that driving a car 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 the car is in good working order, paying attention to road signs among many other rules that act to safeguard against the risks. By controlling the risks of driving in this way the majority of drivers get to enjoy the enormous benefits of driving while avoiding the risks.

Investing is no different. But few private investors take the time to learn about investing, the associated risks and how to control or mitigate them. And, of course, we learn nothing in school or university about how to save and invest properly.

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. I, for one, would very much welcome an initiative from the government whereby individuals in society are encouraged to learn more about saving and 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% 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 investing in risk assets; the returns are generally higher.

Understanding the Risks
The most important risk 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 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, and 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.

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 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:

  • Business risks: the risks that the company will not be earnings the same in five to ten years as it is earning today. This risk is particularly hard to judge. It demands an understanding of different industries, competitive advantages and many other business attributes.
     
  • 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 assess by non-professional investors as different industries can accommodate different levels of debt for a given cash flow stream.
     
  • 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.

Volatility in Markets is Not the Enemy
Understanding what 'risk' really is also helps us stay calm in more difficult market conditions. 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.

Attempting to Trade Markets is a Mugs Game
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 as a strategy 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'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. We like to say that you need to own assets if you want the return from them. Trading assets is a mugs game for the vast majority of private investors.

Rory Gillen is founder of GillenMarkets.com, the online investment website, and author of 3 Steps to Investment Success published in October 2012.