Investing favours the brave

by Neil Faulkner on 05 May 2010  |  3 comments
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Outside of war with France or a nuclear explosion (and perhaps even then) there are very few investing risks that can't be managed simply.

If you are considering investing in a SIPP or an ISA, you may be wondering: What are the risks in investing? How much risk should we take? How do you control risks? I once wrote an article entirely with rhetorical questions, but I think on this occasion you want answers. So I'm going to give them to you.

For readers who pick individual shares or specialist investments there are more things you need to know about investment risk, but all my guidance below is for readers who buy my favourite investments, index trackers and ETFs, with no leveraging (i.e. no borrowing to invest) and no shorting (i.e. no investments that make you money when shares go down in value).

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Reducing risks

Here's how to reduce investing risks:

Costs - The difference between a £100 per month investment charging 1.5% pa and another charging 0.5% pa could be an extra £40,000 in costs over 40 years. Costs are a massive risk. We have a big choice of trackers and ETFs, and many invest in similar things, so ensure you compare their charges.

Tracking error - Index trackers and ETFs don't precisely match the performance of the indices they're tracking. Before investing in one, take a look at its tracking history in its prospectus. If it's rubbish at matching the index, steer clear.

Government meddling - Governments can make unfavourable changes, the most obvious being to raise taxes on investments. The most problematical case is with pensions, because they're so inflexible. Hence, if you're relying solely on pensions, consider spreading the risks by using ISAs as well.

Poor quality investments - A poor investment might never pay off, but by investing in trackers and ETFs you could probably afford it if a few companies drag their feet or even go bust. Track several different major indices from both the developed world and emerging markets to reduce this risk further.

Provider goes bust or commits fraud - In addition to investments going bust, another worry is a bust for your ISA or pension provider, or your broker if you have a normal share-dealing account, and for its bank(s) where it holds your uninvested cash. The same risk applies if an employee stole your money.

I've looked into these risks and consider them small, particularly if you use well-known players. Even so, if you have significant sums, it's sensible to spread it around.

Psychological risk

This risk is important enough to get its own section and big-font heading. After more than a dozen years of investing and surviving two bear markets, I'm convinced the greatest risk for most investors is our own temperaments. It's clear our brains aren't designed to deal with the excitement and fear of bubbles and busts.

If you check your investments several times a day and it thrills you, you probably have the wrong temperament for investing. You're liable to buy when everyone's euphoric (when shares are expensive) and sell with the panic (when they're cheap).

When investing in straightforward trackers and ETFs alone, most of us should have no reason to check their prices daily. Try abstaining for one month. If you can't stop yourself from checking in between, firstly, don't worry: most of us don't have the right temperament. However, you should reduce your investments so that it doesn't shock as much whenever (not if) the market crashes.

Balancing risks against potential reward

More risk can mean greater possible rewards. Putting less money in your savings account and more in shares is likely to be rewarding. The trick is knowing how much risk is appropriate for you.

For tracker and ETF investors, volatility is the risk to balance against. As a rule, the better an asset class is seen to be, the more volatile it is. Shares usually perform better than bonds and cash and they're also more volatile. They go up and down, and sometimes they stay down for several years.

Although the trend for shares is almost certainly to be upwards, they can easily go five or ten years underperforming cash, or even make a loss.

There is one very reliable way to eliminate this problem: don't invest for short periods. Over ten years, the chances are good that you'll outperform cash and get some satisfying returns, whereas if you don't outperform cash and even make a loss, the chances of it being a big loss are fairly small.

Recent question on this topic

• lovemymoney asks:

  Is it a bad thing to have all my finances liquid i.e. highest rate paying savings accounts and N S & I index linked bonds.

  • 
    JoeEasedale answered "Right now liquid is good. I too fail to trust financial advisers who have never failed to give me..."
  • 
    lovemymoney answered "Thanks Joe, i see you are yet another victim of the greedy finacial services industry. Your phrase..."
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On the other hand, with a timeframe of 20 years or more, the risks are yet further diminished, but the chances of doing very well have increased further.

Another way to control the risk is to invest equal amounts each month, rather than use lump sums. The likely rewards will be a little bit lower, but the risk is more than proportionately reduced. If you'd invested in a UK tracker at the end of 1999, when the stockmarket was at its highest ever, ten years later your return is very low. However, someone investing £100 per month since then will have done much better, as they'll have bought more shares during the troughs (because they were cheaper) and fewer shares during the peaks.

Do you need any risk at all?

The longer you can invest, the better your chances get and the lower your risks. A rule of thumb is, the shorter your investment horizons, the less money you should put into the stock market. However, if you have a small cash pile or if you need to preserve it, perhaps for a deposit on a house, then you should not risk money that you're going to need.

If your objective is simply to protect your money from inflation, there are safer ways to do so. You can just beat inflation by tying your money into inflation-linked National Savings and Investment Certificates, for example. Plus, it always makes sense to keep a decent cashpile in an easy-access account for emergencies.

But one thing's for sure: over the long-term, brave tracker and ETF investors are likely to be much wealthier than people who stick to savings accounts.

Please take the time to read about my property, savings and shares strategy, which decreases your money risks further: The dangers of using property as a pension.

Look at some decent savings accounts and cheap index trackers.

More: Two simple ways to invest better in shares | Top 10 index trackers