Diving into shares involves an element of risk, but so does diving underwater.
Cautious investors often complain that the sharemarket looks more like a casino than a source of wealth creation. But looks can be deceiving.
The trade-off for accepting higher risk is higher returns. When viewed over the long term, the potential benefits of share ownership are clear.
In the 10 years to December 2013 Australian shares returned 9.2 per cent a year.1 By comparison, the safety of cash in the bank earned annual interest of just 3.7 per cent with no opportunity for capital gains.
Risk and returns
All investments involve a certain level of risk. In a low interest rate environment, one of the biggest risks is leaving all your money in the bank. Sure your capital – within certain limits – is guaranteed, but it won’t grow in value and you run the risk that the income you receive, in the form of interest, won’t keep pace with inflation.
It’s a similar story with bonds. The interest rate on 10-year Australian government bonds is often referred to as the risk-free rate of return which all other investments are measured against. Like cash in the bank, your capital is guaranteed if you hold your bond to maturity. The risk is that the income you receive will be eaten away by inflation over time.
Risk and volatility
When people talk about risk and shares, what they are often referring to is volatility. Share prices can fluctuate wildly, both up and down, over a week or even a day and that can make investors nervous.
For that reason, many people prefer residential property. Yet the perceived stability of bricks and mortar is partly an illusion. If investors could track the daily value of their property it would resemble a share price graph. You would see short-term fluctuations but hopefully a steady rise in value in the long run if the property was chosen well.
While history shows that growth assets such as shares and property provide the best long-term returns, that doesn’t mean you should ignore defensive assets. Cash and bonds are lower risk and lower return investments but they provide much-needed income in a market downturn and reduce the risk of major losses.
Time in the market
The secret weapon of share investors is time.
Benjamin Graham, the father of modern share investing, said that in the short term the sharemarket acts like a voting machine, but in the long run it acts like a weighing machine. In other words, daily share prices are a vote of confidence or no-confidence in the news of the day, but longer term the true value of a company is recognised in its share price.
By selecting quality companies and being patient you help reduce the risk of losses. You can help reduce risk even further by diversifying your share investments.
Even professional investors get it wrong sometimes and invest in a company which doesn’t live up to expectation. By investing in a broad range of shares in different market sectors you reduce the risk of being wiped out by a single bad investment.
Shares also involve market risk, which is the risk that an entire market will be affected by a difficult economic climate. In the years following the global financial crisis (GFC) Australia was one of the top-performing markets. In 2014 China and India were stand-outs. Next year’s winners may be different again.
The point is that Australia represents just 2.3 per cent of the global sharemarket, which makes us a very small fish in the international pond.2 By investing in overseas shares via a global share fund, you can tap into the best companies in the world and reduce your exposure to a single economy.
Caution can be a virtue, but being overly so is a risk in itself if wealth creation is your intent.