When people talk about a potential investment, more often than not they will go on about how it could make you lots of money. But they don't often talk about the risk involved. The recent sharp sell-off in world stockmarkets is a reminder to everyone that putting your money in shares can be very risky.
Good investors spend a lot of time thinking about risks. If you control the amount of risk you take, you may become a more successful investor and also sleep more soundly at night. But what do we mean by risk?
Volatility is not the same thing as risk
One of the worst things about the world of finance is that it is full of jargon that the ordinary person in the street cannot understand. Finance professionals and academics are often the worst culprits. Ask them what investment risk is and they'll probably mention volatility'.
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Volatility refers to how much the returns of an investment bounce around their long-term average levels. The amount of bounce is measured by the standard deviation of returns. The more volatile they are, the bigger the standard deviation.
For example, in the 30 years between 1983 and 2013, UK shares gave an average annual return (share price plus dividends received) of 11.8% with a standard deviation of 16.4%.
This means that, for two-thirds of the time, returns ranged between 28.2% (11.8% + 16.4%) and -4.6% (11.8% 16.4%). By comparison, index-linked government bonds generated an average return of 5.5% with a standard deviation of 3.7%.
But does high volatility mean high risk? Not necessarily. Granted, if you are 59 years old and you want to retire at 60, you probably don't want all your money in the stockmarket just in case the market decides to take a plunge. However, as I will explain, shares with high volatility can actually be very low risk.
Why you should ignore beta
Beta measures how much the returns of a share have moved relative to the stockmarket as a whole. A share with a beta of more than one will move more than the general move in the market and will be seen as being more risky.
However, this may not be the case in practice. Say, for example, that the stockmarket falls by 30% and a share falls by 50%. This share would have a beta greater than one. But ask yourself, how can a share that has already halved in value be more risky after this price fall than it was before?
It's all about the price
Despite these fancy measures, risk is all about the potential of losing money.This is largely a function of what you pay for an investment. Pay too much and the risk of losing money is often quite high. Pay low prices and the risk is much lower.
This is the basic philosophy behind value investing buying investments for a lot less than they are worth. The seeking out of this all important margin of safety means that lots of things can go wrong and you can still make money, because it's already been factored into the share price.
Stockmarket investors are herdlike.There is also a tendency for them to extrapolate good times and bad permanently into the future. The trouble with this is that good companies quickly become expensive.
When the good times end, the shares have nowhere to go but down. For beaten up shares, lots of bad news is already in the share price. So when things get better, the shares have the potential to be very good investments.
How to risk-proof your portfolio
1. Understand the business. It stands to reason that a water company where demand for the product is largely unaffected by what's going on in the wider economy is a less risky business than a steel mill where demand goes up and down a lot. Study the history and learn about how profits behave in different economic climates.
2. Expect the unexpected. Bad things can and will happen. The crisis in 2008 is a stark reminder of this.
3. Spread your money across different investment classes shares, bonds, property and precious metals all have their place in a well-diversified portfolio. This can reduce risk, as they tend to move in different directions when economies go up or down. That said, in times of sheer panic it's not uncommon for everything to move together as investors try to cash out.
4. Don't be afraid to hold cash. Being fully invested in the markets at all times means that it is more difficult to pick up bargains when they appear.
5. Focus on value. The price that you pay for something is what determines how much money you will ultimately make. It is usually better to buy a decent company at a low price than a fantastic one at a high price.
6. Learn to buy when prices are falling. This requires discipline, but is a lot easier than when prices are going up. That's because there's lots of people wanting to sell and not many wanting to buy. But be prepared for prices to go lower still. You will very rarely call the bottom of a price fall.
7. Be wary of firms with too much debt. It can easily get wiped out when things get really bad.
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