Risks of investing in shares

Everybody knows that investing in shares is risky.  Risks can broadly be classified as market, currency, country, company, liquidity and inflation risks.

Most investors underestimate the risk. Before investing in shares, it is important to consider both your capacity for risk and your attitude to risk.

Your capacity for risk depends on the probability with which you will be able to accumulate capital again if you lose it. For example, if you have a long career ahead of you it would not matter so much if you lose some of your capital. But it would be disastrous if you are towards the end of your career and need the capital for your retirement.

Your attitude to risk is very important. For example, investors who consider themselves to be long term investors often panic and sell at the wrong time when their shares fall sharply. You can lose 100% of your investment in shares in companies. If you invest in an index tracker, the index could fall substantially and may not recover for many years. For example:

1. The Dow Jones fell by over 80% in the 1930s great depression. It fell by over 50% in the 2008 crisis. Do you have enough savings and earnings capacity to not let these sort of falls have a major impact on your life?

2. It took about 25 years for the Dow Jones to recover from the 1929 crash. The Nikkei 225 has still a long way to go to recover from its high in the beginning of 1990. Do you have the savings and earnings capacity to invest after the crashes?

Only you can know your capacity for and attitude to risk. Therefore, only you can make the decision as to whether a particular investment is suitable for you bearing in mind the risk of the investment. 

Few investors over-estimate the risks but many under-estimate the risks. For the latter category, I give below words of wisdom of some of the most highly rated investment professionals:

Peter Bernstein:

• Despite the mountains of historical experience and despite the elegance of the statistical tools and the law of probability that we can apply to that experience, novel and unexpected events are constantly taking investors by surprise. Surprise is what explains the persistent volatility of markets; if we knew what lay ahead, we would already have priced the certain future into market valuations. The roaring bull market of 1958 drove the dividend yield on stocks emphatically below the yield on long term bonds. Nobody even questions the relationship today. Paradigm shifts are normal.

William Bernstein

• If you have saved a large amount for retirement and do not plan to leave a large estate for your heirs or to charity, you may require a very low return to meet your ongoing financial needs. In that case, there would be little sense in choosing a high risk/return mix, no matter how great your risk tolerance.

• Re Long Term Capital Management: Focussing narrowly on only several years of financial data, they forgot the fact that occasionally markets come completely off the rails, often in ways never before seen.

• The popular conceit of every bull market is that the public has bought into the value of long-term investing and will never sell their stocks simply because of market fluctuation. And time after time, the investing public loses heart after the inevitable punishing declines that stock markets periodically dish out, and the cycle begins anew.

• Returns are uncertain but risks can be controlled.

• Risk and return are inextricably connected. If you desire the opportunity to achieve high returns, you have to shoulder high risks. High investment returns cannot be earned without taking substantial risks. Safe investments produce low returns.

• The pattern of annual stock returns is almost totally random and unpredictable. The return in the last year, or the past five years, gives you no hint of next year’s return – it is a “random walk”. The twentieth century has seen three severe drops in stock prices, one of them catastrophic. The message to the average investor is brutally clear: expect at least one, and perhaps two, very severe bear markets during your investing career.

• A near zero real return over 20 years is not an uncommon occurrence. It happened three times in the twentieth century: from 1900 to 1920, from 1929 to 1949 and from 1964 to 1984.

Warren Buffett

• Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.

Robert H Jeffrey

• The determining question in structuring a portfolio is the consequence of loss; this is far more important than the chance of loss. The failure to understand explicitly how much volatility risk can actually be tolerated in a given situation all too often encourages owners to dampen volatility by attempts to time the market which typically leads to mediocre long-term performance results. To the extent that the market is mostly efficient, we can expect only modest improvements in portfolio returns from active asset management.

Scott Johnston

• This is a humbling profession, with minefields all over the place capable of destroying a good performance record built on years of hard work

John Maynard Keynes

• The ideal investment portfolio is divided between the purchase of really secure future income (where future appreciation or depreciation will depend on the rate of interest) and equities that one believes to be capable of a large improvement to offset the fairly numerous cases that with the best wills in the world, will go wrong.

• Markets can stay irrational longer than you can stay solvent.

Gerald Loeb

• If one is lucky enough to possess a sum that is unwieldy because of large size, the important thing to do is to employ only that portion of one’s capital that one does feel he can “double”. It is better to leave the rest sterile than to risk it pointlessly.

• It is true that cash has lost purchasing power … but at a very slow rate compared to the rapid depreciation that can be suffered in a real stock market decline.

• The successful investor will keep his capital idle in times of popular over-investment and over-confidence. He will be sorely tried at times when profits and income are seemingly easy to procure.

Benoit B Mandelbrot

• Financial turbulence is not rare; it is at the heart of our markets.

Paul F Miller

• Many users of MPT seem to see an implied precision in their quantitative machinations and gain a comfort there from that may be dangerous. This danger arises primarily because it diverts too much attention from the big question of whether to own stocks or bonds at all, and in what relative amounts.John Neff

• [After 1967] the Dow Jones Industrials didn’t close over 1000 to stay until 1982. Thus an investor who hitched a wagon to the Dow in January 1966 waited 16 years for a meaningful capital gain. When inflation over the span is considered, the investor suffered a 60 percent loss.

Michael Price

• My mission isn’t to make money in bull markets. My mission is to preserve capital.

Fred Schwed

• Reply from a “sensible fellow” who had spent 25 years trading bonds with other people’s money to the question “What would you do if you had, today, $250,000 of your own?”: “I would put in into 25 envelopes, in cash, of $10,000 each. At the beginning of each year I would take out an envelope and I would risk not living more than 25 years longer. That would give me $200 a week. But, since a man has got to be doing something and I like gambling, I would live on a hundred a week and with the other hundred I would play the horse races. That would give me a real interest in life. Most weeks I’d live at the rate of a hundred – but occasionally at the rate of a thousand.”

Bruce Sherman

• All our emphasis on never losing money is that the bulk of our money is private capital. Private money is a precious, irreplaceable commodity.

Jeremy Siegel

• The returns derived from the past are not hard constants, like the speed of light. Historical values must be tempered with an appreciation of how investors, attempting to take advantage of the returns from the past, may alter those returns in the future.

• The thesis of this book strongly implies that stocks have been chronically undervalued throughout history. This has occurred because most investors have been deterred by the high short-term risk in the stock market and have ignored their long-term record of steady gains. One interpretation of the current (1998) bull market indicates that investors are finally bidding equities up to the level that they should be on the basis of their historical risks and returns. In that case, the current high levels of stock prices relative to fundamentals means that future returns on equities might well be lower than the historical average.

Nassim Nicholas Taleb

• How frequent the profit is irrelevant; it is the magnitude of the outcome that counts. (He gives examples of traders who enjoy many years of success but then suddenly become “wiped out” due to an event that is unanticipated or of very low probability.)