Investors -- novice and seasoned investors alike -- rightly worry about risk. But they don't always regard that risk rationally. And in the process, they leave themselves open to loss.
Many's the time I've heard novice investors flatly refuse to consider investing in the stock market "because shares were too risky."Despite the rise of low-cost index trackers, which spread that risk over a large number of shares, index trackers have dropped in value by over 30% in the last year -- to their mind 'proving' the point that investing in shares is risky.
Yet, as most readers of The Fool know, over the long run, the stock market outperforms both bonds and bank and building society deposits many times over. There's a short term risk of capital loss, balanced against a long term risk of passing up on significant potential gains.
What goes up...
Likewise, more seasoned investors know well that shares prices (and markets) can both rise and fall. Yet many still become emotionally attached to individual stocks, sectors, or investment philosophies.
The banking sector, for example, attracted investors to banks as diverse as Lloyds Banking Group (LSE: LLOY) and Royal Bank of Scotland (LSE: RBS). The former was seen as delivering steady long-term growth and a high dividend payout. The latter was a growth engine: hitch your wagon to Sir Fred, and see your holding rise in value. In both cases, investors have been sadly disappointed.
In this market, these are stories with a lot of echoes. Miners, oilies, AIM micro-caps -- all had a following of supposedly sophisticated investors who are now licking their wounds and ruefully aware that their investing strategies were much riskier than they had supposed.
I spent part of the weekend re-reading several chapters of a book devoted to investment risk -- Against the Gods: The Remarkable Story of Risk, by Peter Bernstein, a longtime investor and market analyst. First published in 1996, it's an enjoyable look at how attitudes to measuring and bearing investment risk have changed over time. I've read it several times and always take away something fresh from it.
Bernstein pulls off two neat tricks. First, he describes the mathematical concepts behind -- say -- portfolio theory in a way that is accessible to the non-mathematical readers. And second, he's not afraid to point out the illogical ways in which individual investors approach the business of minimising risk. As such, Bernstein's book is a great catalogue of bear traps to avoid.
Managing risk can be simple
And the good news is that as a private investor, you don't need sophisticated mathematical models to help minimise risk. For most of those bear traps can be adroitly stepped around by following a few simple precepts -- the sorts of homespun potted investment wisdom that has guided investment 'greats' as diverse as Warren Buffet, Benjamin Graham, Burton Malkiel and John Maynard Keynes.
Buffet, for example, famously avoids businesses he doesn't understand. A lot of his early reputation is down to his application of the 'refrigerator test'. (He liked buying stakes in companies that sold basic staples to consumers -- Coca-Cola being a notable case in point.) In today's market, that would mean buying into companies such as Tesco (LSE: TSCO) and Unilever (LSE: ULVR) -- and it's no surprise to learn that Buffet has been doing just that.
Benjamin Graham, to take another example, was the father of value investing. The basic idea: buy good companies selling on low valuations, and wait for that situation to correct itself, as it inevitably would. He's the source of the observation that while in the short term the market is a voting machine, in the long run it's a weighing machine. To find shares that would excite Graham today, join the Fools on our Value Shares discussion board, and check out the Champion Shares picked out by The Fool's Maynard Paton.
The impact of costs
As most Fools know, one of the most prevalent risks in stock market investing is seeking capital gains eroded by trading costs, fees and commissions. Burton Malkiel, author of A Random Walk Down Wall Street: The Time‑tested Strategy for Successful Investing offers so much advice on avoiding these risks that it's difficult to know where to start.
My own favourites: avoid herd behaviour, don't over-trade, don't pay high commission charges, and spread your risks through diversification. An American, he's a big fan of John Bogle, and much of his advice can be summed up as "invest in low-cost index trackers and investment funds, preferably sheltered within a tax-efficient ISA or SIPP".
As a trained economist, I'll reserve pride of place to John Maynard Keynes, who is often credited with the economic policies that finally saw the British economy come out of the 1930s depression, but who was also a highly successful private investor.
Take one of history's greatest put-downs, for example: "When the facts change, I change my mind. What do you do, Sir?" As the banking sector went down the plughole last autumn, there were plenty of people to whom that could have been applied.
Another favourite quote relates to the folly of sticking to a particular investment strategy in the dogged hope that things will turn round. Be dispassionate, warned Keynes: “The market can stay irrational longer than you can stay solvent."
Malcolm Wheatley owns shares in Lloyds Banking Group.
