Inform yourself about investment risk

Our view on risk is black and white, and it comes to this: If you read "What degree of risk are you comfortable with" and at the end still don’t feel that you have a sense of what investment risk is, then you should not touch risk investments. There is no shame in this, they simply aren’t right for everyone.

Past performance is not a guide to future performance. But history is a good place to start to explore how well different asset classes have performed over long periods, and what can go wrong. You can see in the table at the top of the next page how, providing you take a sufficiently long view, the probability of equities or shares providing better returns than bonds or leaving the money on deposit is very high. These figures are based on analysis of the stockmarket from 1899 by Barclays Capital.

Probability of shares beating bonds or deposits
	Consecutive years of investment
	2	5	10
Deposits:
probability of equity outperformance	67%	75%	93%
Bonds:
probability of equity outperformance	70%	76%	82%

Over longer periods a key issue is whether the returns from any of these asset classes also beat inflation. The CSFB Equity-Gilt Study considered every 10 year rolling period since 1879. Equities did better than inflation 87% of the time, and equities beat gilts and cash 60% and 65% of the time respectively.

So the case for investing in the stockmarket is clearly compelling.

But you must also understand how things can go wrong

Contrary to the perception of many that were new to investment in the decade up to 2000, stockmarkets go down as well as up (the bear market of 2000/2003 being a rude re-awakening). Up to 2000, with only two down-years in the UK stockmarket since 1977, this was a difficult message to get across. From 1918 to 1977 you would more commonly have seen one year in three with the stockmarket declining, falls of 20-30% being commonplace. Then we had an ugly bear market from 2000-2003, followed by a remarkable recovery from 2003-2007, with barely a ripple of volatility. The current bout of turbulence emerged in the Summer of 2007. But through all of these ups and downs the long term trend remained up, you just needed patience.

The average downturn (bear market) in the US stockmarket since 1875 has produced a fall of 32% from peak to trough, and lasted 18 months. Again patience got you through the average downturn.

You could be this unlucky - the accidents of history

You can easily factor into your thinking occasional years of weakness such as just described, as these can be dealt with by patience and a sensible timeframe for investment. But very occasionally, perhaps once every few decades, it can get somewhat worse.

In real terms (that is after allowing for inflation) the US stockmarket peak of 1929 was not regained until 1954 (25 years), and the peak of 1966 was not exceeded in real terms until 1995 (29 years).

We call these “accidents of history” (what Nassim Taleb has more recently called “black swans”). If you had invested in 1970 could you really have envisaged that oil prices would quadruple in the years just after? No. Nor could some of our parents and grandparents have guessed that their lives would be consumed by two World Wars and a depression. Sometimes fate is just going to deal you a tough hand.

This isn’t meant to scare you, just to highlight that you must have a sensible spread to get you through the difficult stockmarket years, and a level of risk with which you are comfortable.

The rewards - they are very significant

To provide balance, it must also be made clear that stockmarket investment has provided superb returns over long periods, of that there is no doubt – for example a typical UK stockmarket fund was up 89% in the 10 years to June 2008 (even with a severe bear market in 2000-2003, and extreme turbulence since Summer 2007), in contrast to just 64% on deposit. Equity income funds did even better, up 110% over the same period.

Going back further, £100 invested in the stockmarket in 1945 has grown to £131,639, with dividends reinvested (Source:Barclays Capital, 2008). If you had alternatively invested into gilts or left your money on deposit the recent values would be just £4,550 or £5,789 respectively.

You have always given me good services, for that I am grateful....
[read more]