Are you scared of putting your savings at risk by investing? If so, good! Never lose that fear because it's completely justified. If you invest you risk losing your entire investment, although for most investments that risk is very remote. But as with all things in life you have to balance risk and reward. The way to overcome your fear is the same as it is for any aspect of your life:
- Learn about the true dangers.
- Assess the benefits you receive for the risk that you take.
- Take action.
For example you probably drive a car, and yet the dangers of driving are real and significant. If we find the true danger by looking up the official statistics we would find that 22,144 people were seriously injured in driving accidents in the UK in 2015. The benefits and freedom of driving far outweigh the dangers for most people. And people certainly have taken action after weighing the risk and the reward, which is why there are 26 million cars on the road in the UK.
The true dangers of investing
The primary risks for investors are:
- Education: The reason why there are so many investment scams is because some people don't know what return is reasonable for a given level of risk. In today's environment a return much above 8% per year will come with a high risk of losing your capital. If someone tells you different they are lying. That 8% is the long-term return of investing in the US and the UK stock market and is likely to get lower as the population ages. The risk you take for owning, say, the UK stock market is that in a typical year you must be willing to lose 20% of your capital without blinking (or selling!). If you're not willing to bear risk higher than that of the stock market don't expect a return more than 8%.
Source: OECD/INFE International Survey of Adult Financial Literacy Competencies
- Not diversifying: About 50% of UK investors do not understand the benefits of diversification according an OECD survey. While we all know the adage about not putting all our eggs into one basket, few people know how to diversify because it requires an understanding of correlation between assets. For example if you choose any two shares in the FTSE 100 they will have a very high correlation. Buying both will double up your risk. But if you buy a FTSE 100 share and a UK government bond, because their correlation is low (they will jig and jag in different directions) your total risk will decrease.
- Too much risk: Two things are of key importance: how much money can you afford to lose and still pay your bills (your risk appetite) and the period of time over which are you investing (investment horizon). If you have a longer period of time over which you can invest you can ride out market volatility and benefit from trend growth. And yet there are many stories about people with a short investment horizon who cannot afford a loss, such as pensioners, being sold investments with a very high risk. Shares, listed real estate and commodities like oil are very risky and the primary driver of risk in portfolios comes from these assets. UK government bonds and high grade corporate bonds are lower risk but can still provide an income. Alternative investments, such as a timeshare in Spain, wine, art, stamps... are often very difficult to sell or to value and come with a very high risk.
- Your behaviour: We often like to blame other people when we make a loss but most of the time we ourselves are to blame. By knowing our own shortcomings we can avoid some common pitfalls in investment. Which of these traits can you identify in your own behaviour? Be honest!
- Overconfidence: You think you can forecast the future. You can't.
- Self-attribution bias: After successfully predicting one outcome by luck you think you are now infallible.
- Sell winners, hold losers: People are reluctant to crystallize a loss by selling a loss-making investment and yet tend to sell profitable positions too soon in the belief that the rally cannot continue.
- Confirmation bias: You read the news headlines and choose to believe only the ones which confirm your view and dismiss the others as fake news. You should consider all points of view and admit that your view may be wrong if credible evidence says so.
- High Fees: You can't control markets but you can control the fees you pay. Over the long term they can be a big drag on the performance of your investments. For example if you buy an investment fund you will be charged a fee. The three choices are active funds, which try to beat the stock market, passive funds which simply follow the market and nowadays there are robo funds where a computer algorithm invests on your behalf (see our comparison). Some well-known wealth managers charge very high fees while adding very little value: entry fees where they take a percentage of your money as you hand it over, management fees while they are in charge of your money and exit fees if you decide to take your money out. If you invest in passive funds your management fee can be as little as 0.07% per year, while the most expensive active funds can charge 2% or more per year whether they beat the market or not. There is strong evidence that most money managers can't beat the market once you account for their fees and when they do it's down to luck rather than skill.
Source: FT.com "How much do you really pay your money manager?", August 26, 2016 by Naomi Rovnick and Aime Williams
Benefits of investing
At the moment one of the benefits of investing is that the safe alternative of cash in your bank account is losing real value. By real we mean that the effect of inflation is eating away at your buying power because the interest on your cash is likely to be well under 1% while the cost of living is rising by 3%. That means the "real" return on your cash is negative and it is losing value over time.
Just as you can save money by changing a washer on a tap or painting a room yourself you can save massively on fees by learning about investment. The cult of celebrity amongst fund managers is finally starting to be drowned out by evidence that if managers with foresight exist they are very rare and seldom consistent over the long-term. So even if you don't decide to invest yourself you will be better off learning more about investment because you will understand any financial advice much better to see if it makes sense for you.
Nobody likes to admit they are ignorant or that they don't understand something. Scammers know this and will try to bamboozle you with jargon. The best defence against scams is knowledge. If you have realistic return expectations for your risk appetite and investment horizon then your alarm bells should start ringing when you're offered high "guaranteed" returns because there is no such thing.
Finally there is an ethical aspect to investment. By investing you will be making a difference. When you buy a share or a bond you aren't just making an investment. You are helping to fund a company and many people use their capital to reward companies that they believe in or not invest in companies which operate in opposition to their beliefs. Ethical or socially responsible investing is becoming easier as there are now funds that invest in line with ethical beliefs. There are also funds that invest according to religious principles. In fact, the cash you hold at the bank, although you think of it as yours, is actually used to fund the bank although we seldom think in those terms. You are providing very cheap funding for your bank that could be earning higher rewards, although with greater risk, elsewhere. Do you really want your capital to make banks richer at your expense?
If you're just starting out the best place to begin is to learn as much as you can. We provide a learning centre with lots of free videos that will help you get started from finding a cheap broker, how to calculate a return so you can compare investments, how to build a diversified portfolio via asset allocation and find out which risk measure is right for you. Remember that if you have questions just go to our contact page.
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