Risk and Investment
Hello and welcome to episode four of Pounds Shillings and Sense with me, Richard Leeson.
Before we get started I want to say thank you to Andy Robinson for getting in touch on Linked In and suggesting that I host Pounds Shillings and Sense on Spotify. A great idea and one that has now been put in place.
In this episode we’re going to look at risk and investment. Risk is probably the biggest reason why people don’t invest properly. For many people the fear of losing money makes them shun investment at all. Others lose money because they don’t manage risk properly, they take chances without even realising that they are doing so. You will never eliminate risk from investment but you can minimise its
impact and affects. You need to deal with the fear that risk causes but you also need to understand the nature of the risks you might be running and plan for them.
John Shedd, an American author, made an observation about risk in our lives. “A ship in harbour is safe, but that is not what ships are built for.” Risk is inevitable in life and that includes investment. We can sometimes let fear rule our lives and allow it to stop us doing what is right for us. Some reports suggest that for many people, fear of speaking in public is greater than fear of death. That is completely irrational - if you are asked to give a eulogy at a funeral, most of the congregation would rather be in the coffin than standing where you are!
How do you overcome that fear? The late Susan Jeffers, an American psychologist, said in her book that the way to deal with fear is to “Feel the fear and do it anyway”. She offered this advice – when fear grabs hold of you, tell yourself “I’ll handle it”.
In investment trying to avoid risk actually causes you harm and opens you to a really big risk that you may not have thought about, inflation. Inflation is the first risk you need to be aware of. It can erode the value of your money more surely than anything else. Let me explain.
When you try to avoid losing your money by “risking” it in the stock market you inevitably end up putting it in a bank or building society because you think it won’t be going down in value.
Let’s look at what happens when you do that…
Remember in the first episode I gave you the returns on deposit accounts? The best rates for instant access accounts are now about 1.5% (usually including bonuses which you lose if you withdraw funds before a 12 month period). The best rate may not be what you are getting – If you are with a well-known high street bank you may be getting as little as 0.20% to 0.60% depending on how much you have in the account.
To avoid your money losing its purchasing power you need to at least match inflation. Inflation is the increase in the cost of living. As prices for goods and services rise – you need more money to buy them. The rate of inflation measured by RPI (retail prices index) in March 2019 was 2.4%[i] a year. If you are getting less than 2.4% interest on your savings your money will buy you less in the future than it does today.
Let’s assume you are saving in an average cash ISA earning 0.84% a year at the moment. With inflation of 2.4% this means your money will have lost 1.56% in a year, which may not sound like much. £5000 would be then worth £4,922 - £78 less. Would you be happy to take £78 and set fire to it? Of course not! But by ignoring the problem of inflation that is exactly what you are doing without realising it. And the longer you leave it the worse it gets!
If nothing changes over the next five years, and inflation and interest rates stay the same, your £5000 would be worth £4,622 a loss in real terms of £378. Over 20 years prices have risen by 72.8% and over 30 years by a staggering 157.6%!
If you go to my website www.poundsshillingsandsense.com you will find a link to the Hargreaves Landsdown website inflation calculator. You can put in your own data and see what inflation looks like over various periods going back in time
Inflation is a much used term and there are two main measures of it RPI and CPI. There are two main differences – what they measure and how they are calculated. RPI includes cost of council tax and mortgages for example, which CPI doesn’t. The formula is different – RPI is a simple average - if there are ten items being measured then you add up the prices of the items and divide by ten. CPI is calculated by using a geometric mean. If you want to know more check out the ONS on the web. In short CPI will be about 1% lower than RPI. But these indices are not reflective of everybody’s spending. They don’t measure the price of everything. What you spend your money on and what I spend my money are very different. People in their nineties probably aren’t buying computer games and those leaving university won’t be buying houses. You may find your personal inflation figure is much higher or lower than CPI or RPI.
You absolutely need your money to be inflation-proofed or you will be losing value. By not investing you run a big risk. But there are of course risks associated with investing, and you need to be just as aware of those as you now are about inflation risk.
This is the risk of buying or selling at the wrong time. Buying into an investment just as the price plummets or selling an investment just before the price soars. Generally the markets move fractions of a percent from one day to the next. Occasionally there are periods where the swings in price are much greater in 2018 the FTSE100 fell over 3% in a single day. Scary? Over ten years you might expect to achieve 70% growth on the FTSE 100 in the past. Losing 3% brings it down to 67%, still a much better return than cash deposits. If you are still worried you can offset this risk by buying or selling in stages, say two or three investments of half or a third of the total. That way if the market falls just after your first investment you can buy the same stocks cheaper with your second investment.
Linked to timing, it refers to how long you invest. The shorter the period the greater the risk. The longer you invest the lower the chance of losing money. If you had bought into the FTSE100 at the start of 2008 you would have lost 28.3% in a year, the following year you would have made 27.3% followed by 12.6% the year after. You need time to even out the ups and downs of movements in markets.
This is really about how bad things will be if you get it wrong. I know of a fund manager who stood up in a presentation and declared that all of his money, all of his wife’s money and all of his father-in-law’s money was invested in his fund. He was trying to demonstrate his commitment to his investment skills. Instead he demonstrated that he didn’t understand impact risk. If it went wrong the outcome would devastate the finances of three people in the same family.
This is closely linked to impact risk. Holding all your money in one investment or one asset is risky. It is easily dealt with and you have probably already jumped to the answer “don’t put all your eggs in one basket”.
Sometimes things happen that affect an entire market, such as rising interest rates and currency movements. You cannot eliminate it. A good fund manager will take account of it in building a portfolio of investments.
This covers the possibility that the company or government you invest with default and you lose some or all of your money. Remember the Greek debt crisis – when they talked about “haircuts” that was a way of saying the Greek government would not pay back all the interest or capital on the money investors had lent to it. Credit rating agencies offer some help by rating the creditworthiness of governments and companies but they don’t always get it right. Two of the big agencies, Standards and Poors and Moodys, both rated Lehman Brothers as an investment grade stock a week before it collapsed in the credit crunch!
This is something we have seen a lot of since the Brexit referendum. It is the chance of losing money because you invested in a foreign currency and the rates have moved. It doesn’t just mean turning your pounds into Euros or dollars it also affects you if you invest in assets that are priced in a foreign currency. For instance if you buy into a fund that invests in Europe, the underlying shares will be valued in Euros.
This is an important one and not very well understood. It is the risk that no-one wants to buy your investment from you when you want to sell it. When that happens supply and demand drives the price down – significantly.
Foreign investment risk
This covers risks associated with political instability and governance. If you had invested in Ukrainian stocks before the Russian army crossed the border you would have had a tough time. And not every stock market in the world is as well-regulated or supervised as the London Stock Exchange. You may find some companies abroad are not willing to issue profit warnings when they should.
As we progress through I will refer back to these risks and tell you what to do to reduce the chance of losing money.
The first step is to avoid inflation risk and only keep as much in deposit accounts as you need to cover your emergency fund, that 3 – 6 months of cash you need to have just in case.
That is probably enough to take in for one episode so that leaves a little time to talk about another good cause. This time it is MND Association – Motor Neurone Disease is a fatal rapidly progressing disease that affects the brain and spinal cord of about 5,000 people in the UK at any one time. There is no cure. One in three who are diagnosed die within the first year. Please check out https://www.mndassociation.org/about-us/key-facts-and-information-about-mnd/
[i] Source Office of National Statistics