Fool's Eye View

[ August 7, 2000 ]

Coping With Risk

By Bruce Jackson (TMFGoogly)

Kilburn, London -- The Concise Oxford Dictionary defines the word risk as:

A chance or possibility of danger, loss injury or other adverse consequences.

That's a pretty broad definition, and definitely encompasses the reasons why many people don't invest their money in the stock market. Essentially, they view it as a risky home for their money.

And who can blame them? Here are some of the reasons why most people don't, and never will, invest their money in the stock market.

1. A stock market crash is just around the corner.

2. Shares can go down.

3. Your money is far safer in a bank or building society.

Any familiar to you? Humans are naturally risk averse, especially so with money. The fear of loss prevents us from taking risks.

All of the above are true. Let's look at them in a little more depth.

1. The last recognised crash was way back in October 1987, when the FTSE 100 index fell over 20% in one frenzied day's trading. Many so-called stock market pundits have been predicting a crash just about every year since 1987. In theory, another one could be just around the corner.

2. Most companies go through a bad patch somewhere in their corporate life. The good ones recover and go onto even greater heights. Some struggle for ever more, either eventually going bust, getting acquired, or spending much of their corporate life in penny share land. One thing is for sure -- a bad patch equals a declining share price, and means shareholders lose money. Long-term Marks & Spencer (LSE: MKS) shareholders can give you chapter and verse on this particular one.

3. You can't lose money by putting it in the bank. In fact, you'll make money, because the bank will pay you interest for the pleasure of your business. Not much, mind you, in these days of inflation, but your capital is safe and growing.

Fool or fool?

Having read the above doomsday scenarios, you'd have to be a fool (note the small F) to dabble in the stock market. Wouldn't you?

Well, the stark truth is that if you want to become truly wealthy, the stock market affords you the best chance of attaining that goal. Better than leaving your money in a bank account, and certainly much better than leaving your money under the bed. Over the past 80 years, these are the numbers:

Stock Market:  12.3% per annum
Bank Account:   5.5% per annum
Under Bed:      0.0% per annum

Although I don't have the numbers to hand, the stock market also handily outperforms property. The numbers paint a very convincing picture -- the only place you should consider investing your money is the stock market. Why therefore do so many people fail to do exactly that? It's back to our old nemesis -- risk. That's why.

Overcoming Risk

It's as simple as ABC.

A. When investing in the stock market, always give yourself a 10-year time horizon. The longer the better.

B. Download and read the CSFB Equity Gilt Study. Here's a couple of key facts and quotes;

i) "Even if investors invest at stock market peaks, equities can substantially outperform gilts and cash." (p41)

ii) "The first 20 years of the 20th century and the 1970s delivered the only three decades of negative equity returns over the last 130 years." (p6)

C. Read (or reread) Nigel Roberts' superb ode to the Queen Mother. Not only does it give an excellent potted history of the past 100 years, but it shows how £100 grew into more than £2m over that same time period. Two more facts:

i) No additional capital was added. Had the Queen Mum added £100 per year, she'd really have been seriously in the money. Not that £2m should be sneezed at!

ii) Note the entry for 1974 -- "At the end of the year the Queen Mum's portfolio has fallen to just £15,362, a level last seen in 1965; she has lost over 60% of the value of her portfolio in just two years. Ouch!" From that low point, the stock market jumped an astounding 149% in 1975, and continued its inexorable upward spiral.

Now What?

Now that you're armed with the facts, you're ready to make your own assessment of risk. Go back over points 1, 2 & 3 at the beginning of this article.

Yes -- over the short-term, shares can be risky.

Yes -- buying individual companies can be risky.

But, over the long-term, a simple index-tracking ISA should see you well. You can start off with (or without) a lump-sum, and add additional funds on a monthly basis. In 10 years' time, you should be well on your way to becoming a wealthy Fool. It's our secret low-risk wealth creating scheme.

Where Next?

Fool's Guide To ISAs
FAQ -- Index Trackers

Related Links;
An Ode To The Queen Mother
CSFB Equity Gilt Study
Why Buy Shares?
Shares Outperform Other Forms Of Investment