We explore the common mistakes made by young investors when they consider high-risk investments.
Many investors have an idea of what ‘high risk’ investments are. Usually, they are seen as investments subject to a lot of short-term movement known as volatility. However, we believe this idea of a risky investment needs to be re-examined, and in fact, what makes an investment ‘high risk’ for many investors is much more complex.
The simple categorisation of stock markets as high risk, and cash as low risk, can be turned on its head when your time horizons change. For an investor with a ten or twenty-year time horizon, volatility isn’t particularly important. They have time to ride out the highs and lows of stock markets. Far more important is that the value grows in the long term regardless of short-term market volatility. Equally, although cash exhibits no volatility, in the longer-term it’s unlikely to keep pace with inflation, so will lose money in real terms. As such, in the longer-term cash can be riskier than the stock market, even if there is more short-term volatility.
So, if volatility does not equate to ‘high risk’, how should we define it instead? Our view is that the key concern of most investors is preserving or growing the real value of their capital over time. And as a result, a ‘high risk’ portfolio or investment is one that exposes them to a high probability of permanently losing their capital. In this way, we become more concerned about the types of companies and portfolios we invest in, rather than just the volatility they exhibit.
High risk stocks
‘High risk’ businesses are those investments that can open you up to a permanent loss of your initial capital. We suggest that these stocks tend to share a number of characteristics:
- Excessive debt - if a business is highly geared, shareholders can lose a disproportionate amount of money when revenues or asset values fall. Profits can be used up paying off interest and debt, and creditors can demand management change course. In a worst-case scenario, a geared business cannot meet its debt repayments and defaults.
- Unsustainable business models – when the revenue profile of a business is unlikely to be maintained investors can become vulnerable. Particularly in the context of climate change which is leading to a shift in how economies and societies allocate resources. Companies producing goods that pollute are increasingly seeing capital and consumer spending moving elsewhere.
- Vulnerability to disruption – an increasing number of businesses are being made obsolete as a result of technological change or changing consumer behaviour. The most obvious examples being high street retailers as ecommerce takes market share.
There will be points in the market cycle when these types of companies will find favour with investors. In many ways there are trading opportunities here, and value can certainly be found in overly pessimistic share prices. However, as long-term positions we need to be aware that they increase the chance of permanently losing capital.
High risk portfolios
A high-risk portfolio is not simply a portfolio full of high-risk investments. If you don’t have the right blend of investments, you can also leave yourself vulnerable to losing capital:
- Undiversified portfolios - one of the basic rules of investment management is that you diversify your risks. By holding securities that move in different ways at different times, the portfolio is less exposed to loss in one individual area. No matter how good an idea appears to be, there are always potential risks. A good example is Japanese equities - once as high as 45% of the global market capitalisation*, it appeared to be an unstoppable engine of technological innovation in the 1980s. Following decades of deflation and structural challenges they now represent closer to 8% of global markets. Today when investors have also crowded into a small handful of stocks it’s easy to forget the importance of diversifying.
- Ignoring valuation – investors often get carried away with a good idea. The danger is that you pay too much, and the price reverts to fair value, even if the business proves every bit as good as you thought. Good companies that have gone up a lot are not necessarily good investments. Finding a company’s ‘fair value’ is complex and it at the heart of investment management but is also a key element of protecting investors’ capital.
- Investing in very low return assets – much of the fixed income market, for example, has moved from being low risk to high risk because the expected real returns have fallen so much. Far from being a ‘safe haven’ as they have been seen historically, investors in bonds could see real losses as they fail to keep pace with inflation.
Our definition of ‘high risk’ investing is not then focussed on the dangers of volatile stocks. In fact, companies with volatile share prices may prove great long-term investments. In a way, if your time horizons are long enough you can see volatility as an opportunity to add value, rather than a risk to avoid.
In our view, high risk investing is to invest in companies or portfolios that expose you to a permanent loss of capital, rather than a short-term loss that can be recovered. Partly this reflects the dangers of poor-quality business models, and partly it reflects portfolio construction decisions that neglecting diversification or valuation.
Investors need to redefine how they see low risk and high-risk portfolios. Volatility is not the key factor for a long-term investor, who should be more focused on permanent loss of capital instead.
*Source: Man GLG/MSCI, 2019
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Investment does involve risk. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance. Rates of tax are those prevailing at the time and are subject to change without notice. Clients should always seek appropriate advice from their financial adviser before committing funds for investment. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable.
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This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.