Giv­ing up

Finweek English Edition - - INVESTMENT -

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.

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