Andrew träffade nyligen Thongma Vijitpongpun som grundade fastighetsbolaget Pruksa 1993 och har varit VD sedan dess. Thongma är en av Thailands rikaste personer och god för drygt en miljard US dollar enligt Forbes. I genomsnitt har Pruksa sett omsättningen växa med 20% per år under de senaste 20 åren.
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What is risk?
An essential part of investing is risk management; in the long run risk management often matters more than picking the highest performing assets at certain points in time. So, what is risk?
On the one hand, risk is the possibility of losing something of value; in investing, this is often losing monetary value. Risk is also about taking action in an environment of uncertainty. While risk and uncertainty may appear to be the same, the two are often separated. Uncertainty is unmeasurable and uncontrollable, while risk is quantifiable and can, therefore, be managed.
In our effort to be as general as possible in our definition of investment risk, we define it as permanent loss of capital, i.e., you end up with your capital being of less value at the end of your investment horizon. The size of the loss is also relevant, e.g., if you lose 5% of your invested capital compared to losing all of your wealth, it affects you in different ways. A 5% loss is likely to be manageable, while losing all your wealth may lead to complete ruin or even death.
Another broad definition of investment risk is to not meet your investing goals, so-called shortfall risk–may it be financial independence at the age of 40, a comfortable retirement at 65, or something else.
In the world of finance, the relationship between risk and return is a central idea; if you take on more risk, you’re expected to have the chance to earn a higher return.
Different types of risk in investing
Investment risk can be general or asset-specific. In this post, we’ll look at some common risks when investing in stocks, bonds, gold, and commodities. This is not a complete list of risks involved, but a few we believe you should be aware of and consider.
The broadest type of investing risk
The broadest type of risk, which is unavoidable, is the so-called market risk. This is a risk that you can’t get rid of if you want to invest in a certain type of asset. If you, for example, invest in a passive equity fund that owns all stocks in the market, you still bear the risk of the equity market.
Risks driven by politicians and central bankers
As you narrow down the universe to specific regions or countries or specific assets, the risk drivers may differ. For example, when you invest in stocks or bonds in a specific country, you expose yourself to political risk and currency risk related to that country. Political decisions can lead to a change in legislation that affects you and your investments, and it can also affect the exchange rate. Lower-yielding assets such as bonds are more sensitive to changes in the exchange rate; a currency that depreciates significantly against your home currency can wipe put your whole profit.
Another risk that is driven by politicians and central bankers and affects you is inflation risk. Inflation reduces your purchasing power, and a minimum goal for your investments is to keep up with inflation to not lose purchasing power over time. Historically, hard assets and precious metals such as gold have been used to protect yourself from inflation. However, stocks should be fine to protect against inflation as well, as businesses can adjust their prices in line with inflation. Lastly, nowadays, some bonds are protected against inflation, e.g., Treasury Inflation-Protected Securities (TIPS).
The other party may fail to deliver on their promise
When investing, you normally bear counterparty risk, e.g., that the other party fails to deliver on their promise. When investing in debt, credit, or default risk is a risk that the borrower will fail on the promise to pay you interest and return your principal.
Illiquidity can eat your returns as well
With most investments, you may expose yourself to liquidity risk, i.e., that it is hard or takes a long time to buy or sell an asset. Some stocks have very low trading volume; hence, it can be hard to buy or sell a sufficient number of shares within a reasonable time. Other investments, such as bonds, might have reduced liquidity due to high par values; hence, there are fewer investors that have a sufficient amount of money to participate in the market.
This latter type of issue can be dealt with through mutual funds and ETFs. Though, mutual funds may only allow investments and redemptions once a month or less and an ETF can, like a stock, have low trading volume; hence, you may still expose yourself to liquidity risk. Liquidity is an issue as it usually leads to higher spreads, and you may also move the price by your own trading as you buy or sell a large part of the daily turnover in the instrument.
Diversify across and within asset classes to reduce overall portfolio risk
The last risk, we’d like to highlight in this post is concentration risk, which means that you hold one or very few assets in your portfolio. First, you might want to allocate money to different asset classes, so your portfolio includes stocks, bonds, gold, and commodities. Many investors also like to add real estate to the portfolio; however, for the average investor that owns the property they live in the allocation to real estate is already likely sufficient or too high.
Then within each asset class, there’s concentration risk, e.g., only investing in a specific stock or sector within the stock market. Throughout the years, many studies have shown that it’s not uncommon for investors to only hold one or a few stocks in their brokerage accounts. Those investors bear a significant amount of company-specific risk, e.g., exposed to poor decisions made by management in that specific company or changes in the market environment that only impacts that specific company or companies of that type.
How to measure investment risk
Volatility measured as the standard deviation of returns is the most common risk measure in finance. There are numerous financial theories and hypotheses based on the assumption that risk is volatility. However, in real life, volatility is hardly a risk in itself. Think about it yourself, if the price of the asset you own increases, is that a risk?
Another way to measure risk is then to only look at downside volatility. In this case, you exclude the volatility on the upside, since that is something you want, and only measure the standard deviation on the downside. Losing less on the downside matters over the long run, as if you manage to reduce your losses, you have a larger principal on which you earn returns.
The final risk measure we’d like to mention is the maximum drawdown risk. Maximum drawdown is the fall in price from peak to trough. You may also want to look at not only the magnitude of the drawdown but also the length of it, or how long time it took until the previous peak was recovered. Maximum drawdown is interesting to look at over long periods and also to see how well a portfolio fared through a large market downturn.
Do not avoid risk completely, manage it
To conclude, when digging deeper into risk and becoming aware of the many risks you expose yourself to when investing, keep in mind that one can also be too conservative. If you put your savings in the piggy bank instead of investing it, you may not have enough in the future. Instead of completely avoiding risk, make sure to manage it carefully.
This post was originally published here.
DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.
Ever heard someone say: “money doesn’t grow on trees”? I’m here to challenge that statement, and my argument is not that most money is made of paper. But rather what Einstein referred to as the eighth wonder of the world. If you want to see what this eighth wonder is up against, check Wikipedia on wonders of the world.
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
The boring part is that it takes time
Unfortunately, compound interest is quite boring for the first 20 or so years. But compounding is your best friend in investing. Let’s make this more real and look at what compounding actually can do for you and some rules to follow to get the most out of this eighth wonder of the world.
When investing in stocks, your returns come from capital gains, price appreciation of the stock, and dividends, when the company distributes a portion of its earnings to shareholders. By staying invested and reinvest you can also make money from compounding.
Three approaches to the world-equity portfolio
Let’s assume you were to invest $100 in world equity at the end of 1987 and let’s compare three different scenarios. Let’s say you can choose 1) no withdrawal (never withdraw any money, instead, you reinvest all dividends), 2) withdraw dividends only each year, or 3) withdraw dividends & gain each year.
Let’s first look at the terminal wealth of these three options, i.e., the value of your investment portfolio today.
If you stayed invested and reinvested your dividends, your terminal wealth would be $1,042 today. If you didn’t reinvest dividends, you’d have $509 today. As you can see if you withdraw all your capital gains and dividends each year, your terminal wealth would end up being about the same as you put in.
Accumulated wealth accounts for your gains over the whole investment period
Though, in the cases where you take out money from your portfolio in the form of dividends or dividends and capital gains you have made more money than the terminal wealth. We’ve therefore taken a look at something we call accumulated wealth. The measure considers all money that you’ve made throughout the time since you began investing at the end of 1987.
With no withdrawals, the accumulated wealth stays the same as the terminal wealth as nothing has been withdrawn. Without withdrawals and full reinvestment of dividends, your $100 has generated you $942 in total gains. The accumulated wealth for withdrawing only dividends was $614, and if you withdrew capital gains as well, it was reduced to $244.
Compounding is free money
We can break this accumulated wealth into four parts: your principal investment of $100, capital gains, dividends, and compounding.
The main difference between the three different choices is compounding. With no withdrawals, the compounding effect created $649 of the $942 or 69% of the wealth created from your $100 investment. By reinvesting dividends, you gained an additional $328 in compounding compared to if you withdrew all dividends–$649 compared to $321 in compounding effect.
In the third alternative where you withdraw both capital gains and dividend, you gained nothing from the compounding effect. You can also see that the dividend and capital gain parts are smaller. The reason for this is what was mentioned earlier that we assume that you don’t contribute any more money to your portfolio. Since you withdraw all gains at the end of each year, it means that some years your portfolio will have a value less than $100 and those years there are no capital gains for you to withdraw, and the base for your dividends has been decreased as you’ve realized gains.
There is more free money to collect
To benefit the most from the eighth wonder of the world—compounding—you must invest for the long term, and you should reinvest dividends. There’s one more part to it, you shouldn’t just put in $100, but you want to contribute more money to your portfolio regularly. You don’t want to end up not having enough money when you get old and expose yourself to shortfall risk. For most people, it makes sense to contribute to your portfolio every month when you receive your salary. You should also consider increasing your contributions as your salary increases throughout your career.
How to maximize your gains from the eighth wonder of the world
To get the most out of compounding, you should follow these three rules:
- Invest for the long term
- Reinvest dividends
- Keep adding money, preferably every month
It’s not uncommon that people find reasons not to start investing or continuously contribute to their portfolio. One such reason might be that the market appears too expensive. That can be a legitimate worry at points but timing the market becomes less relevant as the length of your investment horizon increases.
The key point of this whole post is to highlight that through the magic of compounding there is a lot of additional “free” money to collect. If you’re not invested, you can’t benefit from compounding.
Compounding is what makes your money seeds become a majestic money tree and not just a tiny money flower. Compounding truly is the eighth wonder of the world!
This post was originally published here.
DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.
The risk that really matters when investing is the risk of not having enough wealth to meet your future goal, so-called shortfall risk–may it be financial independence at the age of 40, a comfortable retirement at 65, or something else.
Your piggy bank won’t keep your money safe
In a previous post, we highlighted that while keeping cash may feel secure, you are actually losing wealth in real terms–your piggy bank turns out to be a robber. Investing in government bonds will earn you some return, but if you need your money to grow significantly over time, bond returns are likely not enough.
You need to get on the roller coaster
The asset classes that have historically generated higher returns than government bonds have not offered the same smooth ride. The ride is likely to be more like a roller coaster with ups and downs, and sometimes massive ups and downs.
Throughout a roller coaster ride, most riders will feel both fear and joy. And afterward, there’ll be many riders filled with joy and feeling better than before the ride. They’ve been through fear to end up being better off. But there’ll also be people getting off the roller coaster scared to death and maybe even throwing up. This is a good analogy to describe investors and their different levels of risk aversion.
The difference between riding a roller coaster and investing though is that you don’t have to learn to enjoy roller coasters to enjoy life. But when investing, you generally must accept a bit larger ups and downs—volatility—to enjoy higher long-term returns.
Two types of risk in investing
So, let’s talk about risk in investing, and two types of risk in particular–volatility and shortfall risk. Do you remember playing on a seesaw as a kid? Let’s think about a seesaw when we dig into these two risk concepts.
Volatility: The swings in asset prices. The price of assets traded on exchanges moves up and down every day. Volatility is a standard measure of risk in finance. High volatility can be emotionally painful. But for the long-term investor volatility is not really risk. We define risk as the permanent loss of capital.
Shortfall risk: The risk that you don’t reach your financial goal, e.g. you save all your life, but the day you want to retire you don’t have enough money. This risk is less often talked about, but this is the risk that matters most.
The seesaw of risk
In this seesaw of risk, the left side represents now, and the right side represents the future.
Low volatility today, means higher shortfall risk in the future. Investing in assets with very low volatility today can be comfortable.
When you invest in low yielding assets you get the benefit of your money growing stably; you won’t check your balance one day and see that it’s down by 30%. But the price of that safety is a low long-term return. The risk is that you may end up not having enough money in the future.
High volatility today, means lower shortfall risk in the future
Investing in volatile assets can be painful at times. You will face times when your investment account balance is down, sometimes down a lot.
But these volatile assets, generate a higher return in general and therefore reduce your risk of shortfall. Few financial advisors think about this tradeoff.
Many financial institutions will see volatility as risk and then ask the investor to confirm their level of risk tolerance. If the investor says they have “low” risk tolerance then the advisor will put that customer into low volatility, low return assets. They will have reduced volatility, but they will have increased shortfall risk.
The thing is that most financial advisors won’t be around years in the future when you suffer from shortfall risk. So the lesson is to remember that only you will look after your wealth best.
It’s a balancing act
The All Weather Strategy aims to find a balance. We know that even the biggest fans of roller coasters often feel fear during some part of the ride. Our primary target though is to reduce your shortfall risk, as reducing shortfall risk is what really matters.
As such, we must accept some level of volatility, certainly higher volatility than what a portfolio of only government bonds would exhibit. But we also know, that too much volatility can be so painful it leads to bad decisions.
Our emotions can easily result in bad decisions
It’s not uncommon to see investors getting into the stock market at close to peak levels and then experience a big downturn and sell close to the bottom–an experience that leads to pain and loss. Sometimes the experience can be so painful that the investor never returns to the stock market. To appeal to this kind of investor, we aim to find a balance between volatility and shortfall risk in our All Weather Strategy.
For those who want to build a long-term portfolio
A strategy built around equities has historically been the best way to grow your wealth. No other asset class has outpaced inflation more than equities.
In Thailand since 1999, the equity market has generated an after-inflation terminal wealth almost four times higher than the second-best option, government bonds. But as you can see, investing in the stock market is not a smooth ride; it’s more like a roller coaster.
Let’s re-iterate that after inflation, no other asset class has outpaced inflation more than equities. So, if you want to grow your wealth significantly, you need to focus your strategy around stocks.
Regularly contribute to a long-term strategy
Regularly investing in a long-term portfolio is the best way to build your wealth over time. Long-term investing removes the trouble of watching the market every day and volatility becomes less of a concern. A long-term strategy can reduce your stress.
This post was originally published here.
DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.
Gold has been a store of value for thousands of years and is sought for in times of uncertainty. It has not seen much interest following the European Banking Crisis in 2011. However, recently increasing geopolitical tensions, worsened global economic outlook, and US government debt, are all things that could potentially drive up the gold price.
There is something special about gold
There is usually a discussion around what type of investment gold is. Gold is not a cash flow-generating asset such as stocks or bonds. It is a precious metal with some industrial use, hence, partly a commodity.
But the “commodity demand” is only a small part of the total demand for gold. In another sense, gold could be seen as a collectible as people, for example, buy and hold gold jewelry. The Fed Chair from 1987-2006 had another view:
“Gold is a currency. It is still, by all evidence, a premier currency, where no fiat currency, including the dollar, can match it.” – Alan Greenspan
Gold is in our DNA
No matter how you classify gold, history shows that it has fascinated us for at least five thousand years. Though, pieces of natural gold have been found in Paleolithic caves dating back as far as to 40,000 BC. The Ancient Egyptians seem to have been first with smelting down gold, and the Mesopotamians appear to have been the first to make gold jewelry. The first gold coins are claimed to have been minted in the Kingdom of Lydia in 700-550 BC. So, from early on, gold has been used as money.
In modern times, the British West Indies adopted a form of gold standard in 1704 and is thought to be the first. International gold standards followed in the coming centuries and currencies were often linked to gold or gold and silver until Nixon decided to end international convertibility of the US Dollar to gold in 1971 and by that also put an end to the Bretton Woods system.
Benefits from adding gold to your portfolio
For your investment portfolio, what matters more, is the properties of gold and the impact it has on your overall portfolio. When we look at gold, we look at it as a separate asset. Gold is highly liquid, bears no credit risk, and can work as a true diversifier to your portfolio as it usually has a low correlation to other asset classes.
Gold is uncorrelated to equity
As we’re mainly focused on equities (sometimes blending in a passive bond alternative), we did a study to look at the correlation between gold and world equity. If we measure over the whole period from January 1988 to May 2019, the correlation between World equity and gold has been 3%, which is virtually zero.
Looking at a 10-year rolling correlation, it has varied between 10% and -10% over the past 20 years, which means the two are uncorrelated.
The gold price goes up when equity price corrects
Plotting the price indices of World equity and gold we can see that during the burst of the Dot-com Bubble, the Global Financial Crisis, and the European Banking Crisis gold price rose, as equity price fell. Gold price tends to go up in significant equity-market downturns.
Store of value for thousands of years
Gold has been a store of value for thousands of years and is sought for in times of uncertainty.
“There’s something about gold. I’ve thought about this for a number of years, and I reached a blank. It’s almost as though, technically speaking, the ability of having a stable price, has great value.” – Alan Greenspan
During this long equity bull run and times of no inflation following the European Banking Crisis, gold hasn’t shown any exciting performance. However, the currently increasing trade tensions, worsened global growth outlook, US government debt, among other things, may attract more market participants to gold and start moving the price up.
Gold can work as a hedge and diversifier. If equity markets were to fall, the gold price could rise. At worst, it should store your value and is uncorrelated to equity.
This post was originally published here.
DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.