Getting started with stock market investing - Risk vs. Return
Stock market investing has a severe image problem in Belgium. People tend to equate the stock market more and more with a casino. Maybe if you are a big shot trader or investment banker in London, you can succeed by "playing" the stock market. After all, they make it their life's work to know the ins and outs of the financial world. But surely, you, as a private investor are probably better off keeping your money in a savings account or putting it in some government bonds?
What most people don't realize is that there are different kinds of stock market investing. You can essentially determine yourself with what level of risk you are comfortable. Are you a hardcore gambler and looking for extreme levels of excitement? Sure, the stock market has you covered. Are you 60 years old and looking for a more-or-less low-risk investment with decent returns? No problem!
You ofcourse don't have to believe this just because I said so. In fact, it is better if you don't. This brings to mind the first and foremost rule of investing: don't invest in something you don't understand just because somebody said so. This is so important that I will say it again: please don't buy magic beans because some dude told you they are the next great thing! This is how people lose all their money and start hating on the stock market. Invest in a financial product because you have done your research and believe it is a sound decision, even given the risks involved.
This is ofcourse easy to say, given that you are not an investment banker in the City. But don't be scared away by all the jargon that is used in the financial world. At its core, it all comes down to a simple set of principles which, when understood in depth, makes you understand 90% of all investment-talk you might possibly encounter.
But let's not wait any longer and get started with our first core-concept!
For Dutch speakers:
Return - Rendement
Bond - Obligatie
Stock - Aandeel
1. Trade-off Risk-Return
This principle basically states that if you want high returns, you need to be comfortable with higher risk. If you want low risk, you need to content yourself with lower returns.
To make sure that you understand what this really means, please take a look at the evolution in time of the value of two investment portfolios. An investment portfolio is just a collection of different financial products: stocks (aandelen in Dutch), bonds (=obligaties in Dutch), gold etc.
The value of portfolio 1 seems to fluctuate quite aggressively. The curve looks like a mountain range with high peaks and low valleys. Think about the horror of buying this portfolio when its on a peak after which you immediately see it taking a nosedive. Risk is basically the variability of your returns, and in this case, oh boy, they are quite variable over time. Over the long term, you see that you will make quite a nice profit (high returns) but in the meantime, you are in for a rollercoaster...
While the graph of portfolio 1 was more like storm-at-sea, portfolio 2 is a lot more alike to a calm day at the beach. In this case, if you are unlucky enough to buy the portfolio at one if its peaks, you will not really freak out that much. But while that is a positive point, you can immediately see that you have to sacrifice some return to get that nice feeling of peace-of-mind. The long-term increase in value is a lot lower than in the case of portfolio 1.
What about time?
For the high-risk case (portfolio 1), you can see that while the value of your investment can fluctuate wildly in the short-term, in the (very) long-term you can count on a really nice return. Ofcourse, you need to have quite a high number of different financial products in your portfolio for this to hold true (this is called diversification, and will be handled in the next section). If, for example, you only have stock of 1 company in your portfolio and this company goes bankrupt, you can keep waiting until hell freezes over, you are never seeing your money again.
Practically, this means the following:
- If you don't need the money that you are investing for a very long period (>20 years), you can invest in a portfolio similar to portfolio 1.
- If you need your money back quite quickly, you should do better investing in a portfolio similar to portfolio 2. If you need to use that money to buy a house after 5 years, you can be quite sure that most of it will still be there ;)
When reflecting on this, it is actually quite logical. People are generally risk averse: this means that they prefer low risk (low variability) investments over high risk (high variability) investments. This means that people will only be willing to accept higher risk if they are compensated for it. In this case, the compensation is a higher expected return after a long period of time. This is why this tradeoff is so fundamental in the world of investing.
How risky are different investment options?
Before we go to actual financial products, I will show you the same kind of idea for something a bit more exciting:
Stealing an iPhone is not very risky: if it works, you 'win' the value of that iPhone. On the other hand, if it doesn't work and you get caught, you probably have to pay some sort of fine to the police. The variability here is not vey high, maybe +500 (if all goes well) vs -1000 (if all goes wrong). Ofcourse, the probability of getting caught is not very high, so your 'expected' return will be about €200.
We can do the same kind of reasoning for other criminal acts, like bank robbery. If all goes well, you can walk away with > €100 000. If all goes wrong (and you get caught), you get nothing and you (most probably) have to go to prison for a looooong time, which is probably worth a lot of money to you to avoid. The graph above suggests that taking into account the probability of getting caught, the 'expected' return is a lot higher than stealing an iPhone.
What can we conclude from this analogy? Does this mean that all petty thieves will stop stealing iPhones and start robbing banks because of the higher 'expected' return? I suppose a lot of gangsters doing long prison sentences would disagree with this conclusion. Basically, it depends on your risk appetite. If you are a person who goes to the casino, goes skydiving and has unprotected sex, you will most likely feel better about robbing a bank. If you are afraid of doing outdoor sports, buy a lot of insurance and worry about the future, you will probably choose to steal an iPhone.
How does this hold true for 'investing' in the long-term? Like I said, for this to hold true, you need to have multiple 'products' in your portfolio. In our crime analogy this means that you have to attempt different bank heists using slightly different techniques. If you just rob 1 bank, its a bit all-or-nothing: either you succeed or you fail, either your company becomes the next Google or it goes bankrupt. If over time you keep doing different bank heists, your return will eventually be close to your 'expected' return because hey, sometimes you lose, but then again, these failures are compensated in full by the times you actually get away with those large bags of cash!
The same is true of the stock market. Here is the same graph as before, but then for financial products:
At one extreme, you have cash at the bank, probably in a current or savings account. This is veeeery low-risk. Probably soo low-risk that you don't even realize there is a risk (some people in 2008 were unpleasantly surprised by this non-zero risk). Ofcourse, you pay a price for the certitude that it will always be there: you get an interest rate which is very low.
At the other extreme, you have venture capital. In short, venture capital is any investment in start-ups. Ofcourse, these start-ups go bust all the time, without any warning. They are the dictionary definition of very high-risk. But if you invest in >100 start-ups and you are not a complete moron, over time you will most probably have a higher return on your investment than if you would have put that money in a savings account.
In the middle you have bonds (slightly more risky than a savings account), then real estate and finally stocks (with a large distinction between lower- and higher- risk classes of stocks).
So what does this mean for me?
This doesn't mean that we all need to be bank robbers or venture capitalists. It also doesn't mean that we all need to put all our money in a savings account or start stealing pencils at the office. The amount of risk that you should assume is determined by two main factors:
1) Your risk appetite: are you a daredevil or rather conservative?
2) Your time horizon: when do you need to have the money back (in full)? In 1 - 5 - 10 - 20 years?
By having a time horizon of 20 years, you can actually be a very conservative person while assuming a lot of risk with your investments (but always diversify, diversify, diversify!).
This is essentially the reason that young people are often recommended to have a large percentage of stocks in their pension saving accounts, which makes it slightly more risky. When you are 25, your retirement is far far away => this means that while the value of those stocks in your pension saving account will fluctuate in the short term, in the long term you are almost 100% sure of a high return on investment. I always cringe when a 20+ year old tells me they started pension saving and they choose the "Defensive" profile.
To conclude, nobody can really advise you how much risk you should take with your investments. It all comes down to the time horizon of your investments (when do you want to get your money back) and your risk appetite.