At a recent presentation I was giving to investment club members, one of the younger people in the audience (remember that I am somewhat older, so mid-20s is young in my book!) asked what the risk was with investing, and could they lose money? My answer was short and honest: you certainly can lose money and in the worst case, you could lose everything if the company you owned shares in went bust.
This totally shocked the audience, with the murmuring that followed suggesting that they consider this risk to be far too high, and as such they’d rather stick with money in the bank.
In the light of the collapse of African Bank I think it is important to revisit the risk aspect to investing. It starts with the fact that as a shareholder your risk in an individual stock is absolute. You could lose 100% of your investment. This is because shareholders stand last in line when things go wrong. The South African Revenue Service, banks and preference shareholders would be in the front of the queue to be paid out. However, while the downside risk is absolute, it is more than offset by the potential reward. In theory, that reward is unlimited as share prices can rise to any level.
So, shareholders get a potential 100% loss, offset by unlimited potential upside. If you want to reduce that risk, then you start moving to lower-risk asset classes such as high-quality debt (Government bonds), money-market accounts, cash in the bank and ultimately cash under the bed.
However, debt instruments are not risk free, just lower risk. The African Bank collapse did see Absa Money Market account clients losing 0.3% of their capital as the fund had 3% exposure to African Bank debt. That debt lost 10% of its value in the Reserve Bank bailout of Abil. Judging from the reactions on my Twitter feed, people invested in the money-market funds thought their money was 100% safe. That really is an issue of the selling institution properly explaining the facts.
The only 100% safe thing for your money is putting it under the bed, and that assumes your house doesn’t burn down and that nobody else f inds the money and takes it. Of course, while this is safe, inflation would still erode the value of the money, so your risk is zero − but your reward is actually negative.
These are the two extremes: zero risk but negative reward, versus 100% risk and unlimited reward. That is ultimately the trade-off, risk versus reward. The problem as illustrated by the investor club audience is that people are overly scared of the risk side of the equation. But we can manage that in many different ways.
Firstly, as I always say, we should invest in quality. Forget second-tier and riskier listed stocks. Thus we can make plenty of money with a much lower risk profile. Secondly, we buy for the long term (decades), using the power of time. Thirdly, we diversify across asset classes, industry sectors and geographies (the easiest way of doing this is through a simple exchange-traded fund).
These three risk-reducing tools do not in any way remove risk, but it significantly reduces it. With that lower risk comes reduced reward. With our potential reward being unlimited, I am more than happy to give up some of that potential upside for a reduction of my downside risks.