The biggest investment risk you will take
Very little work is done to help people understand what risks they face with investments, and you’ll have had ‘investments may fall as well as rise, and you may not get back the money you invested’…until the cows come home.
The phrase is correct, but so is ‘weather is unpredictable, you may not get the sunshine you planned for’, or ‘restaurants may be terrible as well as good, and you may not get to the satisfactory experienced you paid for’.
Take the first statement: ‘you may not get back the money you invested’ , what would have to happen for that to actually happen? Lots of people lose money on investments, how does that actually occur?
The investor sells at a price lower than he paid.
I got the timing wrong and needed the money for another purpose – I had gambled that the price would rise before I needed the money.
I needed the money – I forgot to set aside a cash reserve to protect me from having to sell early.
The value fell! I didn’t know that could happen, I didn’t know what would happen in the future. I couldn’t afford to see my money fall in value.
I read the news today, all the other investments are going up except mine so mine must be bad.
My friend told me my investments are not good and I could lose all my money.
A fraud.
In 2019 UK investors lost £657 million to investment fraud.
The investment went bust.
It’s very important to stop and think about what risk actually is: it’s not that the market goes up and down, that’s actually guaranteed.
The tide here was guaranteed to come in – it’s the driver who made the error, the risk lies with the driver’s decision making, not the tide.
The markets always go up and down, it’s investors decisions that cause the problem.
Risk is the likelihood, measured as a percentage, that an outcome will not be as expected.
“Riskiness of an asset depends on who owns it” – Mark Carney, ex-governor of the Bank of England.
“We consider risk to be the combination of impact (the potential harm that could be caused) and probability (the likelihood of the particular issue or event occurring).” FCA
“In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision.” SEC
Risk is not volatility – in the main investment markets volatility is volatility and is guaranteed. Volatility is the measure of how much the price of an investment fluctuates from the average – it’s not an indicator that something might go bust.
Have you ever sold out of an investment at a loss? If so, is that investment still there, and if you’d held till now would you be back in profit?
Fraud
Many people try to push the envelope and so are easy pickings for fraudsters. If something really was that good, they wouldn’t have to advertise it, and why wouldn’t ‘they’ keep it all to themselves?
Going bust
It is very rare that a publicly listed firm actually goes bust; the chief risk to an investor is failing to diversify properly. Most retail investors will only invest in a fund which is already spread across many individual companies, and they should also be spread across several different funds.
Carillion was a construction company that went bust in 2018 – it had been valued at £1bn.
If you had invested in the FTSE index it was listed in you’d have been paid a 2.34% dividend yield that year instead of losing your money.
If you invest in the FTSE100, the only way to lose all your money is for the UK’s biggest 100 companies to all go bust at the same time. (Possible technically, but not probable).
For income investors the outline of risk as probability of an event occurring is very different; the volatility in asset prices is not the same as volatility of asset income. This is a chart showing the FTSE100 since 2000:
The income fluctuates but it doesn’t stop – that’s because it’s paid by all 100 companies.
The share prices fell in 2008 but the income still ended the year being 4.43% of the starting value. Even in 2020 the income ended up being 4.68% of the January starting value.
An investor in the FTSE has always had a positive cash return; that does lead to the conclusion that the only way to lose money on the FTSE is for the investor to sell at a price lower than initially paid.
Better still, dividends reduce the risk of loss of an investment by paying back that cost. If you buy an investment that yields 1% per year it’s easy to see it’ll take 100 years to pay back 100% of the cost of the investment.
If investors ‘bought’ the FTSE100 index in January 1998 at a value of 5883, then by the end of 2020 they would have received £4,771 in dividends, so leaving only £1,112 of the original capital at risk.
When you buy an annuity you pay with 100% of your capital, so have a 100% capital loss on day one.
Annuities demonstrate simply that a fluctuating capital value is not where the financial downside lies in investing for income – it’s the loss of income that’s key.
If income is maintained, then the underlying value of the capital is of no direct consequence to the investor’s lifestyle. IF the income fails however, or if its is insufficient, then capital losses appear as capital is sold to generate cash to pay for living expenses.
Successful income investing is only achieved by an investor who understands the difference between income and capital, and who is actually investing for income. Lack of understanding brings the very real possibility of making the wrong decisions in a market downturn and creating actual losses to capital – the driver who blames the tide for submerging his car.