Investing & Risk – The Long-Term Case for Equities
Doing well with money has little to do with how smart you are and a lot to do with how you behave. Morgan Housel, The Psychology of Money.
Money Ambitions
Maybe you have had an inheritance, a lottery win, or just accumulated some savings, and you are considering investing for the first time. Before you do, it might sound strange, but it is important to understand your relationship with money. That is, the money you have today, the money you would like to have in the future, why it matters to you, and what you want to achieve from having money.
Money is Emotional
Investing your money is more about adopting the right attitudes and behaviours than it is about a detailed plan. While investing involves evaluating the future, it does not require predicting the future. Of course, life events such as having a family or buying a house need to be considered, but nothing about life is inevitable. We live in an uncertain and confusing world. Understanding the risks you are prepared to take to achieve your financial ambition is essential for your financial health and emotional wellness. The following is intended to guide you through some basic investment concepts, risk types and potential returns. Hopefully, it might enable you to be financially successful but also feel happier about your money and what it can do for you.
What is Investing?
Investing involves the acquisition of an asset or item to generate an income or an appreciation in value over time. Understanding investment involves looking into the future and critical concepts such as risk, compound growth, liquidity, and money’s changing value over time. So, let’s start by looking at some basics.
Time Value
If I offered to pay you £100 today or in 12 months, which would you prefer? It’s easy, right? It makes sense to take the £100 today. A bird in the hand and all that. But what if I were to offer you the option of £100 today or £120 in 12 months? It’s not so obvious, is it? Your decision will now depend on how keen you are for money today versus next year and your assessment of my ability to pay you in 12 months. The first concept is your time value of money. The second concept is your assessment of my credit risk. That is the risk that I may default or skip the country to avoid my obligation to pay. So we know that £100 today is not worth the same as £100 later, and we also know that higher risk needs to be compensated by a higher return.
Liquidity Risk
But what if you decided to take the £120 in 12 months and 3 months later change your mind and decide you needed the money after all. Well, you have two options. First, you can suggest an amount I might pay you to cancel my future obligation. Second, you could find a third party to pay you today for my promise to pay later. However, you have no certainty regarding either of these options. This is your liquidity risk. Cash is considered liquid as it can be spent. The promise to be paid in the future is illiquid as it cannot be spent. Different investments offer different levels of liquidity risk.
Compound Growth
Now assume that I was prepared to offer you an income of £100 a year for the next 50 years. In 50 years, you would have £5 000 if you didn’t spend any of it. Alternatively, I offer you a lump sum today to invest in the stock market for the next 50 years. How much would I have to provide you to make you no worse off in 50 years? Well, we don’t know what the stock market will do over the next 50 years. But suppose the stock market returns are similar over the next 50 years as they have been over the last 65 years. (The Numis Index suggests this was about 11% pa in the UK). You might be surprised to know that I would only have to give you one payment of £27 today for you to have £5 000 in 2072. Indeed, if you took your first 5 year’s income of £100 in the first option and invested those five annual payments in the stock market rather than just saving them, then this would yield you a total of £74 260 by 2072. A 15-fold improvement on the simple savings plan. This, while only an illustrative example, demonstrates the enormous power of compound growth, where returns are earned on your returns.
Duration
A critical factor in the ability for returns to compound is the duration or length of the holding period. In the above example, if you held your stock market investment for a further 5 years beyond the 50 years, your total investment would be worth more than £125 000, 70% more. Duration is the main reason Warren Buffet is so wealthy*.
Inflation
So, you have built up some savings that are not earning any significant interest. Worse still, the inflation rate has been rising, which means that the real value of your savings is declining as measured by the Retail Price Index or RPI. Inflation is a measure of the purchasing power of money over time. When the rate increases, the amount of stuff you can buy with your money declines. Not only is your preference for money next year lower than it is today, but due to inflation, you will be able to buy less with it. This is precisely the situation where you should consider investing.
Asset Types
There are several broad asset classes to consider: property, bonds, equities, and alternatives. Each category has its own distinct risk, return, and liquidity profile. For example, investing in property tends to be lumpy and illiquid. However, property can also offer attractive income characteristics. Bonds, such as the debt issued by governments or companies, offer a known future value and income and have fewer unknowns than riskier assets. However, while bonds might have their place in a well-diversified portfolio, we are in a period where both inflation and interest rates have been rising. Historically (in the 1950s and 1970s), these have not been good periods to hold fixed-income securities such as bonds. Alternative investments are assets that don’t fit into the more conventional categories. These include commodities, private equity and multi-asset funds, crypto assets and collectables such as fine art, classic cars, watches. Alternative investments tend to be more speculative and specialist. While they can offer spectacular returns, they are considered risky. They tend to form only a small part of most diversified portfolios.
Equities
Equity is a share in the ownership of a company. Shareholders have the residual rights to what is left in a company after paying all other stakeholders. So, by definition, a share is risky as the amount left after any accounting period is unknown in advance. Indeed, if things go badly and there is nothing left or worse, shareholders can be wiped out. However, two critical factors compensate equity holders for assuming such risk. While other stakeholders such as employees, suppliers, landlords and lenders are paid in fixed contractual amounts, shareholders’ returns are uncapped and theoretically limitless. The second factor is that the entitlement to this residual return is compounded by the reinvestment return on the company’s assets. Each year, assuming the business is profitable and earning an adequate return, the company will re-invest to expand. This generates growth for shareholders that is compounded over the long term. Equities in successful companies are long-duration compounding assets with unlimited theoretical upside. It is these features that make them so attractive to long term investors.
Long Term Returns
At Dowgate Wealth, we are equity specialists and consider that any serious long-term investor should have exposure to the growth potential offered by equities. In its latest review of equity market returns, stockbroker Numis demonstrated just how dramatic this effect has been in the UK stock market. [see chart via link to Dowgate Wealth site].
https://dowgatewealth.co.uk/insights/investing-risk-the-long-term-case-for-equities/
Sources: Evans, Dimson & Marsh, Numis, January 2022
If you invested £1 in 1955 in each of the following assets, this chart illustrates what they would be worth today.
If all you had done was keep up with inflation, then your £1 would be worth £20. Sounds OK until you realise that this is just telling you that what you could buy with £1 in 1955 typically costs you £20 today. Despite not spending your money for 66 years, you can only use it to buy the same amount of stuff.
If you had invested your £1 in money market instruments or high yielding deposit accounts, your £1 would be worth £57. That’s more like it. You could buy nearly three times as much stuff with your money as you could in 1955.
If you had taken a bit more risk with £1 and invested in longer-term bonds such as UK government gilts, it would now be worth £140. This is starting to feel much better. You can now buy seven times more stuff.
Now, this is where things really start to happen. Look at the £1 invested in shares over this period. In the lowest risk shares (those of the larger, more established companies), your £1 would be worth £1 210, giving you 60 times more stuff than in 1955.
Keep going, and if you invested £1 in the highest risk shares in the smallest companies on the stock market, it would now be worth a staggering £26 480. More than 1 300 times more stuff, potentially life-changing in terms of its effect.
Short Term Risks
So the answer is easy, isn’t it? Take all your savings today, invest it in the shares of the highest risk, smallest companies and wait for 66 years. By 2088 your £10 000 will be worth £13m in today’s money. We can all be Warren Buffett, given time. Not so fast; take another look at the chart. Notice that the scale is logarithmic and look at the period around 1975. See how the share price charts dip strongly, and the gradient of the inflation chart rises noticeably. In 1972 things looked fine. By the end of 1975, not so much. From January 1973 to December 1974, the UK stock market lost 75% of its value. The £1 you invested in shares in 1955 buys you less stuff in 1975. Think about how this would make you feel. Imagine the people planning to retire and live on their savings in 1975. It’s not so easy after all, is it?
Loss Aversion
Investment can be intensely emotional and psychological. Any investor who loses 75% of their wealth in 24 months and has not made a real return on their money over two decades of investing would begin to doubt themselves. In fact, behavioural studies show that we feel the pain of loss approximately twice as much as pleasure from gain**. Such circumstances as those which prevailed in the mid-1970s would test our loss aversion to breaking point. Even the most committed long-term investors would temper their conviction. The truth is that the long term consists of multiple short terms, and we live in the moment with all the emotional burdens and biases that accompany daily life.
Risk Appetite & Portfolio Construction
These periods of market reversals and crashes demonstrate that the flip side of return is risk. An old adage neatly summarises the philosophy that links risk and returns: a ship in a harbour is safe, but that is not what a ship was built for. The same is true for equities. They were not made for being safe***. They are, by definition, a risky asset prone to greater volatility than other asset types. Yet, as we have seen, equities also offer the highest potential return for those willing and able to assume the risk. Understanding your risk tolerance is crucial to bespoke portfolio construction.
Equities for the Long Term
Despite all the numbers, data and jargon, investing is more about emotion and psychology than we might believe. How we see the future matters, but the future is unknowable, and therefore investing involves risk. Risk offers the potential to earn higher returns, but owning equities is not for everyone at all stages of life. However, at Dowgate Wealth, we believe that the opportunity to compound returns makes equity exposure highly attractive for long-term investors.
In subsequent articles, we will look at the different ways of investing in equities and getting the exposure that makes sense for your preferences and requirements.
Jeremy
27/03/2022
* In 2018, Warren Buffett’s net worth was $84.5 billion. Of that, $84.2 billion was accumulated after his 50th birthday. $81.5 billion came after he qualified for Social Security, in his mid-60s. Warren Buffett is a phenomenal investor. But you miss a key point if you attach all of his success to investing acumen. The real key to his success is that he’s been a phenomenal investor for three-quarters of a century. Had he started investing in his 30s and retired in his 60s, few people would have ever heard of him. Consider a little thought experiment. Buffett began serious investing when he was 10 years old. By the time he was 30, he had a net worth of $1 million, or $9.3 million adjusted for inflation. What if he was a more normal person, spending his teens and 20s exploring the world and finding his passion, and by age 30 his net worth was, say, $25,000? And let’s say he still went on to earn the extraordinary annual investment returns he’s been able to generate (22% annually) but quit investing and retired at age 60 to play golf and spend time with his grandkids. What would a rough estimate of his net worth be today? Not $84.5 billion. $11.9 million. 99.9% less than his actual net worth. Effectively all of Warren Buffett’s financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years. His skill is investing, but his secret is time. That’s how compounding works. Morgan Housel, The Psychology of Money Chapter 4. Confounding Compounding.
**Daniel Kahneman and Amos Tversky coined the term loss aversion in 1979 in a paper on subjective probability. Loss aversion is part of prospect theory, a cornerstone in behavioural economics.
*** Joint-stock companies were first developed by the Dutch to share the risks involved in their maritime journeys of discovery to the Far East and the New World.
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