It can pay to be an optimist in this pro-business economy

Last week, I compared driving a car to investing. Everyone can enjoy the benefits of driving if they mitigate the risk of accidents.

So it is with investing.

If you understand the risks in investing and mitigate them you can benefit from the superior returns that risk assets have delivered over time compared to bank deposits.

I also outlined that, in terms of the various risk assets that one can invest in – such as equities (shares), precious metals, long-dated bonds and hedge strategies – equities, which include property shares, have delivered the best returns over time.

Yes, there are risks when it comes to investing in equities.

The returns from equities are dependent on the health of the underlying economy. As we can’t tell the future, we can’t be sure that prosperity will win the day over deflationary, inflationary or recessionary conditions.

But the fact remains that, in the past century, it has paid to be an optimist, at least in democratic, pro-business economies.

As an example, in the UK over the 19 years from 1995 to 2013 inclusive, £10,000 (€12,700) left in bank deposits would have grown to £21,500 for a 4.1 per cent compound per annum return.

The same £10,000 invested in a FTSE 100 index tracker fund (exchange-traded fund) would have grown to £44,500 (before costs) for an 8.2 per cent compound per annum return.

UK equities delivered double the returns of bank deposits over this period despite an Asian crisis, a Gulf war, a banking crisis and the ensuing recessions.

While we can’t tell what the future holds, history suggests that equities are generally the way to go if you can take a medium-term view (five years plus).

But equity investors must mitigate the risks in owning individual businesses. These risks might be categorised as:

the business risks;

the financial risks;

the valuation risks.

In my experience, private investors underappreciate these three risks. Many buy shares on a whim or after listening to a colleague in a bar or after reading some opinion in the media.

The odds of this approach to investing working out are very low.

Business risk might be defined as the risk that a certain company will not be generating the same level of earnings in five years’ time as it is today.

A recent example of hidden business risk is Tesco. Structural changes in its market have undermined its long-term profitability.

While it is easy to see that now, it was not so easy to see it five years ago when investors were buying the shares at higher prices.

Financial risk might be defined as the risk of inappropriate levels of debt which can undermine an otherwise sound enterprise and lead to a total loss of shareholder value (equity).

We Irish grew up with an attitude that the banks were blue-chip stocks to be held for the long-term. But we were wrong.

Before 2002, the Irish banks were solid, but after that they loaded up with borrowed money and lent it against overvalued assets, such as property.

In doing so, management lost everything for shareholders.

Coca-Cola

Valuation risk is the risk of overpaying for a company to the extent that you compromise the returns that you can subsequently receive from that company. A good example of overpaying for even a great company is Coca-Cola.

Its share price peaked at $43.50 in mid-1998 (see chart above), some 16 years ago.

In the intervening period, Coca-Cola’s earnings and dividend have grown by 7.3 per cent compound per annum. So, the problem for investors in Coca-Cola shares back then was not a lack of subsequent growth in profits or with management.

Rather, investors grossly overpaid for Coca-Cola shares in 1998 to the extent that they compromised the subsequent returns from the shares.

In 1998, investors were paying 40 to 50 times earnings. This is the same as accepting an earnings yield of 2-2.5 per cent from the shares at a time when the US 10-year Government bond was offering a risk-free 6.2 per cent yield.

Accounting is the language of the markets and if you are not proficient with the numbers it can be difficult to determine financial or valuation risks in individual shares.

But, in my view, business risks are even trickier to determine. Entire sectors can lose their way or become obsolete due to changes in regulations, technology or consumer preferences or an increase in competition.

While you can buy and hold a property, it’s not wise to approach equities with the same mentality.

In Ireland, we tend to favour physical property investing. But the risks are largely the same.

For business risk you might substitute ‘location’ risk. Financial and valuation risks are the same.

An honest appraisal of the calamity that befell investors in Irish property since 2008 might conclude that from 2003 to 2007 people simple bought grossly overvalued property and that they used too much debt.

The combination proved lethal, as it normally does. Start small At least in the stock markets, you can start small and buy assets from your savings over time without any need for debt.

The reality, then, is that if you are interested in savings and investing through stock markets you must learn how to control the embedded risks.

If you are not confident that you can assess the risks in individual companies as I have outlined them, then consider investing through funds.

While funds come with added costs which reduce your potential returns the benefits are still worth it as through diversification funds control many of the risks outlined earlier.

In GillenMarkets, our preference is for stock market-listed funds, and these include passively managed, index tracking exchange-traded funds and actively managed investment companies (trusts).

When compared to non-listed unit-linked funds from the life companies, both fund types come with lower costs, better transparency and less administrative hassle.

There are those who would have you believe that volatility in markets is the risk you must avoid.

Their mantra is, ‘You must buy low-sell high to avoid the dreaded volatility’.

This, of course, is nonsense.

You must own an asset if you want the returns from it.

That asset might be a property or a portfolio of shares, and the fact that investors make changes to their portfolio (or basket) of shares does not change the fact that they, too, own an asset.

In contrast, trading markets is a mug’s game and it can only work for a narrow minority just as winning at the poker table can be consistently achieved by only a narrow minority of professional card players.

Warren Buffett says it best: "Playing poker is a zero-sum game. Money may be changing hands but no new money leaves the room."

The stock markets too are a zero-sum game in the short term and trading markets short term is akin to playing poker. If you bought a house in 1970, it is worth a lot more today despite the recent calamity.

That’s because the Irish economy grew, consumer incomes grew and higher incomes now allow today’s buyer to pay a higher price for that same house.

The same applies to companies. As their earnings in aggregate grow they are worth more and over time their share prices rise to reflect that.

Like property, stock market investing is not a zero-sum game on a medium- to long-term view.

Everyone can benefit from the wealth creation if they own assets. Rory Gillen is author of 3 Steps to Investment Success and founder of GillenMarkets, Ireland's only subscription-based online investment newsletter at gillenmarkets.com. For a copy of both articles send an email to info@gillenmarkets.com