Fool's Eye View

[ August 31, 2000 ]

Is Investing Getting Riskier?

By Nigel Roberts (TMFNigel)

Chippenham, Wiltshire -- In the last few years of the 20th century, many investors had forgotten about risk. Throughout much of the 1980s and 1990s, stock markets basically went up. What risk was there of investing in the stock market? Well, for investors who started investing in the last 20 years -- which is most of the people who read the Motley Fool, by the way -- investing became perceived as almost risk-free. All that changed at the start of the 21st century. The start of the new millennium saw the massive rise in technology and Internet stocks, and then in March we saw the massive sell-off; if you have been investing in technology stocks (and many many Fools do) then you don't need me to tell you that the year 2000 has been a very volatile one!

This volatility has put many investors off investing, or has led them to retreat into what they perceive as being safer investments. Who can blame them? If you invested in Baltimore Technologies (LSE: BLM) -- which as many Fools know has been my favourite, but very risky, investment over the last 18 months -- you would have had to ride a real roller coaster of emotions. Just look at this chart of the share price over the past 12 months: how could any Baltimore investor stand the stress?

But the recent bumpy ride has woken investors up to the fact that risk is playing an increasingly significant role in their investment lives. Now that tech stocks look set to be moving on a recovery track I thought I would take a look at risk and volatility involved in investing in the stock market in the 21st century.

A century of volatility!

What will the 21st century bring? Who really knows? We can't predict the future, and I won't even try. But one thing that I am 100% certain of is that the volatility of the market is going to increase. It is going to increase because it is now so much easier and so much cheaper to trade in and out of stocks; also the ease of access to information now means that people are able to react to breaking news quicker than ever before. I used to think that more information would lead to a more "perfect market", where everyone was possessed of the facts and so the share price would "correct"; in reality, more information means less certainty, and is leading to increased volatility.

More volatility means more risk. Risk is the chance that your investments will go up or down, and so the greater the volatility the greater the risk. Now, greater risk is not necessarily a bad thing -- after all, greater risk means greater potential returns -- but usually investors only see risk as a negative thing. We define risk only as the risk that our portfolios will go down, not up. Yet volatility swings both ways, and to get the greater returns on the upside, we have to tolerate the gut-wrenching dips on the downside.

Risk can lead investors to panic

As the volatility of the stock market increases in the future (and I believe that the stock market as a whole is getting more and more volatile, not just technology stocks), the risk of failure increases. Most investors are not very good at accepting the downside of risk; the risk that their portfolios will fall sharply over a short period of time. If you take on more risk than you can stomach, you are likely to bail at the worst time, when your portfolio is way down and you have lost your courage.

Private investors have a habit of selling their shares at the worst possible time. When they have lost the courage of their convictions they will sell, and conclude that the stock market is just too risky a place for their hard-earned money. By selling at the bottom they lock in their losses on shares that, if they had the courage to hold on, may well have recovered strongly in just a short period of time.

Just look at the graph of Baltimore again, and then have a look at what people were saying about the company when the share price hit the low of 300p in May. With the shares now standing at over 800p, have the company's prospects actually changed so much? No, essentially the business is the same. Now that the share price is rising strongly, investors are feeling so much happier; has the business changed? No, just the perception of the risk, as investors see their own losses turned into profits. Baltimore is still a high-risk investment, but now the share price is riding high many investors are once again forgetting the risk that the volatility in the share price brings.

Probably the most important thing any investor can do is to work out what his or her own risk tolerance level is, and make sure they only make investments that are within that tolerance. Jim Slater once described this as your "sleep level"; if you find that your sleep is being disturbed by your worries about the risk of your investments, then don't invest quite so much money. He suggested selling down until you can sleep comfortably.

But don't exaggerate the risk, and don't be too confident!

Everyone's perception of risk is influenced by their recent experiences. The last few months have hurt many investors, and so now they perceive the risk of investing much more highly, probably too highly. But long term investment in the stock market is much less risky than sticking your savings under your mattress where they will be eaten away by inflation. During the tech stock boom, many investors found that they could invest £1,000 and see it turn into £2,000 almost overnight. They thought that investing was easy: or, more importantly, they thought they were great investors who would be able to repeat the performance time and again. Many people become over-confident. They attributed their portfolio growth to their astute strategy rather than to the investment climate as a whole.

And don't worry so much!

Many investors find their emotions jumping from optimism to pessimism on a daily basis. One day they are "up" and have confidence, the next day they are "down" and worry that the stock market is overvalued and heading for a crash. When the market goes up, they cry that they did not have the courage to follow their convictions and invest more, and when it goes down they are upset they didn't pull out sooner. It's important to recognize that over the short term the market bobs up and down, but over the long term the direction is up. Forget about the short-term movements and concentrate on the long-term goal of financial independence.

So how should we approach the 21st century?

With more volatility and so more risk becoming an inherent part of investing in the stock market, what should you be doing? Remember why you invest. Believe it or not, the biggest risk to your financial security is to do nothing. The greatest risk for most people is not investing at all; too many people have too much money tied up in savings accounts that barely keep up with inflation. In the long run, the best place for your long-term savings is the stock market. The best way to overcome the risk of investing is to invest for the long term, and by that we mean 5 years or more; preferably much more. If you need money for a new home or a new car next month, or next year, the stock market is a risky place to invest; put the money into a high-interest investment account.

Don't expect too much!

Beating the market is hard; just look at the performance of the two Fool managed portfolios, the Rule Shaker and the Qualiport. Since 1918, the stock market has returned about 12% per annum. If you move the start date back to 1900 then this falls to 10%. This is the sort of return that you should be planning for. If you expect to make 20% or 25% return year on year you will be severely disappointed, and remember: the returns will not be smooth. Some years you might make 50% or even more, others you will lose money. In your good years, don't get too carried away with your success, and in the bad years don't beat yourself up about it too much!

Invest for the long term, and try to smooth out the peaks and troughs by investing regular amounts of money, known as pound cost averaging. When the market falls, you are able to buy more shares for your investment pound. If you believe that stock markets will rise over the long term, then you should invest your money regularly on a steady basis. Short-term falls will actually increase our eventual long-term profits, not decrease them. That thought should help you to sleep better at night, don't you think?

Where Next?

Risk and reward
Paul Marshall looks at how to measure risk