‘We over estimate what we can do in the short term and underestimate what we can do in the long term.’
Below is an introduction to investing with a focus on RISK.
Why Save for a long time?:
There will always be Risk:
Who am I when it comes to Risk?:
-What is your Attitude to Risk?:
-How much will losing your Money affect you?:
-What do you want: Luxury Item or Necessity?
Reducing Risk
-Diversification of your Savings:
-Reducing Risk towards the end of your investment period:
-Being Financially literate:
Why Save for a long time?
The amount you need for items such as education and retirement is eye watering! Houses can cost a lot of money too.
However you can build up a substantial amount of money by having:
- The discipline to save and
- Knowing what you are doing when you are choosing and managing your investments.
You can then hope to buy your dreams!
Why is it important to invest properly for the long term?
The Magic of Compounding:
If I invest KSh10,000 (and no more) and it earns 10% interest a year,
then I will ghave at the end of:-
10 years over KSh23,000
20 years over KSh61,000
30 years over KSh158,000
40 years over KSh 410,000
And 50 years over KSh1,067,000
I have added NO money to the original KSh10,000.
As long as I receive 10% a year this KSh10,000 will have grown to over a million shillings in 50 years time. This is the magic of compounding.
(Do note the other side of the coin!
If I leave KSh10,000 in my bottom drawer for 50 years and there is an inflation rate of 10%, the KSh10,000 will be worth KSh 57 in today’s money!)
Risk
There will always be Risk:
Before you begin long term investing remember that where-ever you put your money there is some risk that you will lose some or all of it.
Countries have revolutions and can go broke, stock markets can crash, banks can go bankrupt, and money that you have put under your mattress can get stolen.
More insidiously your money can be slowly eaten away by inflation.
Your job is to manage this risk.
- You assess the risk of having your money where it is.
- You look at the benefit of having it there.
- You make a judgement call- is this the right place to have your money?
Will a riskier Asset make me more Money?
For Assets that are traded in the financial markets, the financial markets expect a higher return for a higher level of risk
Investors (the market) need to be paid for the amount of risk they are taking.
High risk investments require a high return to attract money.
Low risk investments need only pay out a low return to attract investors.
e.g. The U.S. Treasury Bill (T Bill) has a very low return because it has a very low risk. Investors don’t need to be paid a premium to lend their money to the US government through US T Bills. They are pretty sure to get their money back.
Investing in Chinese small ‘Start-up’ companies will require a high return for investors to be interested.
It does not mean that the high risk investment presented to you has the potential to make you a lot of money.
There has to be good reason why this proposal has the potential to make money.
This may just be a bad investment. You may be dealing with thieves.
You could lose some or all of your money.
Note: Conservative v’s higher risk investing:
A conservative investment? A higher proportion of the money invested is in low risk investments. This type of investment will include savings accounts, and government bills and bonds.
A higher risk investment? A higher proportion of the money invested is in assets such as equities, your friends business ‘Start-up’ company, smaller companies, in frontier or emerging markets, Private Equity, and commodities etc).
The higher risk of loss means investors require a higher return to invest in these instruments.
How much Risk should you take?
There is no right amount of risk : return that fits everyone.
The higher return you earn every year, the more money you will have at the end of your investment period. The higher return usually comes with higher risk.
An Example:
David puts 1,000,000/- into his savings account in his bank for 10 years.
This gives a 2% return a year.
This is a low risk investment.
There is a low probability that he will lose some or all of his investments.
David believes there is a high level of probability he will have 1,218,994/- at the end of 10 years.
He is comfortable earning a lower return (that may only just keep up with inflation) and being fairly sure he will have the money.
He is happy NOT to have the possibility of more money at the end of 10 years because he doesn’t want the risk of losing some of it.
Sally invests 1,000,000/- for 10 years in higher risk equities.
She is expecting an average return of 10% a year.
If she gets what she expected she will have the much larger sum of 2,593,742/- at the end of 10 year.
Sally is not certain of the amount that she will end up with.
There is a level of probability (albeit low) that she could end up with half of what she started with i.e. 500,000/-.
There is a level of probability (again albeit low) she could end up with over 3,000,000/-.
She is comfortable with the investment because the probability of receiving approximately 2,593,000 is high enough for her to accept the risk.
Neither David nor Sally have made a poor investment. David wanted to be sure of getting 1,200,000/-.
Sally was willing to take the high risk of loss to have the possibility of getting the higher amount.
Both are managing their risk return options to suite their circumstances.
Your job is to choose the investment that suites your need given the particular objective you have.
Is the amount you are going to receive at the end worth the risk of loss you will be taking?
Who am I when it comes to Risk?:
- What is your attitude to Risk?
- How much will losing Money Affect you?
- What do you want- Luxury Item or Necessity?
What is your Attitude to Risk:
The risk of being fearful
Some people are risk takers and some are more cautious. Which one you are will affect how you invest your money.
It is important you are comfortable with how much your investments can potentially fall and rise in value.
If your money falls in value will this keep you awake at night?
Will you sell everything in a panic if the financial markets drop in value, and the value of your investments fall with the markets?
Then you must remain in conservative investments. (Less likely to fall far in value.)
The value of your investments will not have the same opportunity for growth, but nor will you lose a lot of money by selling your investments, in a panic, when they have fallen in value.
Are you, however, the sort of person who can keep an eye on your investments, but sleep easy and stay invested if your investments fall in line with the financial markets?
You can then consider higher return but higher risk investments.
An example:
George feels panicky about big money. His friend, Jim, advises him to buy an investment property in Nairobi for KSh 10,000,000.
Jack does buy the property, but he is nervous.
Unfortunately because of a pandemic the value of his property falls in value to KSh 6,000,000.
In panic he sells.
He will lose KSh4,000,000 (KSh10,000,000 – KSh 6,000,000 = KSh 4,000,000)
Note that George didn’t sell because of a studied change of opinion through analysis.
He was not emotionally prepared to live with such volatility.
Sally has also bought a property in the same area for KSh 10,000,000.
Her property falls in value in line with George’s loss.
Instead, after analysing the new situation, she is comfortable that the pandemic will pass. She feels the value of the property will rise over time.
It does and has risen to KSh11,000,000. She has made no loss.
She will be better off by KSh1,000,000 (KSh11,000,000-KSh10,000,000 =KSh 1,000,000)
Sally is better suited than George to this sort of investment.
George would have been better over the long run if he had put his money in conservative investments that could only fall a little in value.
Conservative investments don’t have the potential for as high a return, but conservative investments are also less likely to fall in value by as much as higher return but higher risk investments.
Note also: This is not to say never sell investments if they fall in value. If there is good reason to believe the investment will never recover in value it may be sensible to cut your losses and sell.
So what are we learning here?
If you are going to panic when investment values fall, don’t go into volatile investments.
You will be much better off going for the slow and steady ‘tortoise’ like investment rather than the fast but more erratic ‘hare’ like investment.
The risk of being greedy- “Getting rich quick”:-
There are projects, assets and ‘start up’ companies that, if you invest in them early, will make you very, very wealthy.
BEWARE: There will also be people who will try and sell you a sack full of gold at the end of a rainbow.
How will you know the difference?
Think carefully first before investing.
People who are successful investing in high risk high return opportunities usually put in a lot of work understanding potential investments.
They will also probably have the resources to do the research required.
If you want to get rich ‘Quick’, use money you can afford to lose.
Think very, very carefully before you use your children’s school fees or your own pension for these schemes.
Note again: There is a good chance that if you invest wisely, over a long period of time, you will make good money.
How much will losing Money affect you?:
If you take a little money from a big savings pool you can take a greater risk than if you take a lot of money from a little pool of savings.
The question to ask is: “If this investment doesn’t work, how much will it impact my life?
If the answer is: “We will have to sell our house and live rough” then maybe you need to choose a conservative investment.
On the other hand a small amount of money out of a big savings pool for high risk investments may be quite reasonable.
What do you want: Luxury Item or Necessity?
The importance to you of what you are going to buy affects the level of risk you are willing to accept.
Jack wants $500,000 to buy a lovely, luxury plot on the Mediterranean.
Sally wants $500,000 for the best life time education for her daughter that she can imagine.
Sally might sensibly invest in more cautious investments than Jack. The consequence to her of losing 30% of her investment means a sharp down grade in the quality of schooling that she will buy to for her daughter.
Jack might sensibly take on higher risk, higher return investments to be able to add on a private swimming pool to the house. If the investment works out he gets his swimming pool. If he loses 30% of his investment he might have to buy a smaller Mediterranean house.
The consequences are probably not as serious for Jack of down grading to a small Mediterranean house, as the loss of a very high quality education would be for Sally’s daughter.
Time Frame
Before you tie your money up in a long term investment try and make sure you are not going to need this money suddenly.
If the value of your long term investment has fallen just when you urgently need the money this can be very expensive.
Reducing Risk
We all look for the highest return, but at the lowest risk.
How do we reduce the risk of losing some or all of our money?
Though there is unavoidable risk in investing, we don’t want avoidable risk.
We can avoid unnecessary trouble if we look for the following:
- A well regulated environment:
The financial regulators who oversee the financial system are competent and work within a well functioning legal system.
If someone tries to steal your money they will be stopped (and put in prison!) by the financial authorities.
- A solid financial institution with a good reputation amongst their peers:
The financial institutions should be independently audited and under the supervision of competent regulators. - The financial institutions are well managed.
Diversification of your Savings:
Investing your eggs into a number of different baskets is one of the most effective ways of reducing the risk to your wealth.
This is Diversifying your wealth.
You have invested your money into different assets that, as far as possible, do not relate (correlate) to each other.
Diversification reduces the risk of loss of all your money.
If you are invested only in one asset, e.g. a large property, and you lose this, you have lost everything. If you have invested in many assets, the loss of the one asset will not effect you as much.
Diversification will also reduce the volatility of your investment.
Example:
Jack puts all his KSh 90,000,000 savings into a plot of land at the coast. His Investments are NOT diversified. He sees that land prices are rising fast and he will make a lot of money. This is correct if property continues rising fast.
Unfortunately , due to political uncertainty pre to an election, the price halves.
His savings are now worth KSh45,000,000.
Julie investments are more diversified.
She divides her KSh90,000,000 into three assets.
- A much smaller plot of land at the coast. The original price is KSh30,000,000.
Due to the same political uncertainty the price subsequently falls by half to KSh 15,000,000. - Government T Bonds. The original price is KSh30,000,000.
The price remains the same. - Overseas mutual funds. The original price is KSh30,000,000.
The price remains the same.
Julie is now left with KSh75,000,000. (15,000+30,000+30,000)
As you can see Julie diversified her savings. When the price of property at the coast fell she still had KSh75,000,000 while Jack was left with KSh45,000,000.
Through diversification Julie is less at risk from a fall in value of one of the assets.
Jack could have made more money if property had a higher return over the long term than Government T Bills and Overseas Mutual funds. However this investment came with a higher risk.
Note Julie’s assets should NOT be ‘correlated’.
Correlation is the measure of how closely one asset moves compared to the other over time.
Obviously, if Julie’s three assets, Property, T Bonds, and overseas mutual funds rose and fell at the same time and by the same amount there would be no value in investing in the three different asset types. She would have lost the same amount as Jack.
Reducing Risk towards the end of your investment period
Within about 7 years to cashing in your investment start moving into less volatile financial instruments that will not halve in value just when you need to cash them in.
Your money is moved from equities, property, friends business etc into bonds and finally into short term T Bills and cash.
So, for the final short period of your investment you have moved into lower volatility, lower return assets such as bank savings account, short term treasury bills etc.
You have moved to a ‘Short term’ investment portfolio.
Being Financially Literate
The better you understand the principles of investing the less likely you are to lose money by making basic mistakes. or to be taken for a ride by a dishonest salesman. Read and talk to people about money and investing. Build up your knowledge base.
To help you learn about investing:
Morningstar.com
Morningstar.co.uk
ft.com/financial-literacy
In addition you can search for phrases such as ‘Financial Literacy’ on the internet.