The stock market – a risky business?
Let’s talk about risk.
From a purely anecdotal view, perceived risk is the primary factor why people tend not to focus on building an investment portfolio from a young age. If you picked up on my book review article of Rich Dad Poor Dad and read the book, you will know that one of the things Kiyosaki advises is that people should be focussing on building assets, not cash. So why do so few people actually have a plan to do this and execute it?
Sure, we can talk about depressed wages, out-of-reach house prices, and other factors affecting millennials’ ability to do much beyond merely living, but I think people have an amazing ability to thrive in these sorts of circumstance. Relatively speaking, I would imagine most IFG readers to be in pretty good financial shape, or at least have the potential to be.
I don’t have the data to back this up, but if I were to go out on the street or around an average workplace and conduct a survey of how many assets people owned that were generating them passive income, I think most people would not own any.
And yet, they can afford a luxury leased car on the drive, a watch that cost them a month’s salary, and a smartphone in their pocket that will probably cost them close to £1000 when you factor in all the costs over the course of a typical contract.
What is driving this? The immediate gratification of a nice life, I suspect. But I think it is also to do with the notion that investing for the future comes with a risk that people aren’t willing to take on in exchange for their hard-earned cash. Money in the bank is comfortable, safe, and provides a great comfort blanket. Investing can sometimes be perceived as a dirty word, synonymous with risk, gambling, and throwing your money away. Of course, our educated readers won’t have this view.
When you factor in inflation, simply keeping cash is not a great place to be. If you accept this, then I would argue that you must also accept the view that cash is a sort of investment in itself – you have chosen where to put your money (i.e. in your bank) and you will bear the consequences of that decision, largely through inflation because whilst your balance remains the same, the costs of life are increasing. Since cash is then a sort of investment, you owe it to yourself to look at alternative investments to protect and grow your capital.
We have briefly discussed the sorts of things you might generally consider as investments in this article. I don’t really want to go into that here: I want to focus more on the risk side of things and explore the psychology that comes with investing. and particularly the stock market.
The Stock Market
This is typically the one area where people are scared to get involved. From conversations with non-investor friends, their view of the stock market is that there is undoubtedly money to be made, but that it isn’t for them, or they feel that they are not knowledgeable to choose a particular share or fund (whereas they’re happy for all of that to be delegated through their pension provider, for instance). So they’re ok with exposure to the stock market in general, as long as they’re not hands-on with it.
I take quite a simple approach to risk when it comes to the stock market. I think that people should invest in themselves by spending the time and money to tool up and become comfortable with how the stock market operates, how to research companies, and ultimately how to pick good individual shares. This is a personal process culminating in you allocating at least a bit of money into the stock market to see how you operate. Reading the books is fine, but practice is key to test your temperament and stock-picking ability (running a fantasy portfolio just isn’t the same).
If you do all of these things and then become comfortable enough to start putting proper money in to the stock market, you can decide what sort of risk you want to take by virtue of the type of company you choose. Going for a big £5bn blue-chip in theory bears much less risk than going for an unknown £20m tech company who aren’t making any profits yet. So you will end up with a portfolio of stocks which naturally vary in risk, thereby giving you a nice spread of risk. For instance, you might choose to allocate a maximum of 10% of your stocks portfolio to smallcaps – that way, even if you lost all of your money in these riskier stocks, you’d only be losing a maximum of 10% of your overall pot. On the flip side, if you did really well, it could really help your overall performance. It’s up to you to look at your circumstances, the type of investor you are, and how much risk you can bear to decide what sort of risk you want in your portfolio. Of course, higher risk can equate to higher rewards, but you need to consider the downside too.
Whatever sort of risk allocation you choose within your stocks portfolio, my own view is really quite simple: that is, if I do my due diligence and I’m confident in my research, there is no reason for me to sell the share until such time as something fundamentally changes from my original investment case. Your view might differ – and that’s also fine.
What to do if my shares are falling?
Shares are quite peculiar once you start investing yourself as a DIY investor instead of simply delegating it to a fund manager.
I say that because once you have control of your own account and easy access to the buy and sell button, there is a psychological tendency to obsess over the share price. I am pretty sure that this is a psychological phenomenon resulting from the fact that you are now the one in instant control which is now as easy as logging into your online account (not even a phone call needed to buy/sell), and that share prices, by their nature, are ‘live’ and you can get a quote on demand to understand how much the market is willing to pay for your shares. Thus it becomes very tempting to quickly get out of a falling stock, or to chase a rising stock which you didn’t buy last week as you think it will keep going higher.
This is why a lot of private investors in the stock market get spooked out of selling their shares too early. Being able to see your investment physically dwindle by more than 20% can be difficult to see and you often lose sight of your original investment case in cases like that; as a result, it can be tempting to cut your losses and hit the sell button.
I’m not actually saying that’s necessarily a bad thing to do; in fact, it can be a good thing. My point is simply that any decisions should not be as a result of panic – it needs to be a carefully considered move.
I really recommend reading The Art of Execution if you want to explore real-life experience of the psychology of when to sell.
If you are thinking about picking your own stocks, be sure to read our article on how to screen for sharia compliance or alternatively we can check sharia compliance for you and assist with zakat calculations through our advisory service.
Comparison with property
Compare the stock market with investing in something much more illiquid like property, it is very quickly apparent how psychology differs in that scenario. If you bought a property for investment and the market then slumped and the house was worth 20% less, you are not very likely to ring up the estate agent and instruct a sale. Instead, you’d probably be thinking the opposite – ‘I’m definitely not selling in this market. I paid 25% more than current prices!’ (a 20% loss would need a 25% rise to get back to break even).
Why is the psychology different across different investment classes? As I said, I think the danger of having live prices and the ability to sell instantly (as with shares) can give problems to the investor in making them too rash and cause them to sell at the first sign of any trouble. Whereas holding would have been a much better strategy.
To counter this, it is important to recognise the phenomenon and not be spooked unnecessarily either way.
Let’s look at an example.
Let’s say you bough the well-known FTSE 100 stock, Persimmon, in early 2007. You would have paid around 1400p per share. Within a mere 18 months or so, the shares were trading at around 250p per share. You would be down over 80% on your initial investment, which is a staggering amount (as a side note, this also goes to show that you can experience incredible losses even in big blue-chip companies – see Carillion as a recent example). So the £5,000 you put in is now worth £1,000 and you’re fast running out of ways to avoid the topic when your wife asks how the shares are doing.
Now you’d face a choice as you saw your investment dwindle. You could be one of those people who automatically cull stocks when they’re around 30% down and never look back. The great thing about this approach is that you get rid, take the loss, and make it an automated process.
However, I personally think approaches need to be more subtle than that for stocks you’ve researched well. Unless something had fundamentally changed, why would you sell something for less than you paid? The market might not be giving you the price you want now, but if you’re right in your initial investment case, the market will eventually catch up. I don’t know this particular stock, Persimmon, very well but given its sector (construction) and the time period we’re talking about (pre-2008 crisis), I’m going to assume there was sufficient reason to sell here.
However, if you held a long-term conviction in both the company and the economy, you’d be handsomely rewarded at this point – you’d be in the green by around 75% which is pretty good going bearing in mind that cash over the same period would be worth less due to inflation (£5000 today gets you less than it did in 2007). So your £5,000 investment would be worth around £8,750.
So I hope I’ve given you a glimpse into how your mindset can affect your attitude to an investment and the decisions you make when you are actually invested in that class. Whatever you are invested in, the key is not to enter unless you are fully researched and confident. What you do after that point must be the result of a carefully thought-out process and not simply you being spooked out of your position.
As ever, I’m looking forward to your thoughts on this whole topic as I’m sure there are some interesting anecdotes.
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