Over time, those who have invested money into the world equity markets have generally done best. However, investing our hard-earned money, and the risks involved, can make any of us feel nervous.
Any decision you make involves risks. The decision to invest is no different. Whatever you invest will go down in value as well as up. But as we will see, even deciding not to invest also has them.
The two biggest destroyers of wealth are you, the reader, and inflation. We all make errors when investing our own money, and the cost of what we want to spend it on will go up over time.
How do investors harm their returns?
Investment Markets around the world have no emotions. Those who invest in them do.
Markets move in cycles moving from boom to bust and back again over time. Investors themselves also move in cycles.
When markets are doing well, we all want to be a part of it. We become greedy. We see other investors making money and want to make some of our own.
We always believe markets will keep on going up. We may take higher risks than what might be right for us at the time. We also may invest speculatively with money we cannot afford to lose.
During a temporary market decline, fear is what an investor feels. Market declines are a test for any investor. Many have not experienced a serious one. Most will want to react, thinking it will help the situation.
Many may try to spot the moment markets begin to fall and switch into cash until markets start to recover.
The problem is predicting short-term market moves is extremely difficult. Even professional investors struggle. The danger is missing out on the recovery. Imagine a scenario where you invested in the FTSE All-Share Index between 31 March 1999 and 31 March 2018. If you had missed out on the 30 best days, your investment would have fallen by 65% instead of rising by 37%.
How does inflation ravage wealth?
Some may prefer keeping their money in the bank. Cash in the bank cannot lose its value. Indeed, cash might keep its absolute value. However, inflation will reduce its purchasing power over time.
Inflation has been between 2% and 3% for the past three years. That does not mean it will not be more than this. It exceeded 5% in the recent past (Autumn 2011) and could do so in the future.
Even at 3% inflation, £100,000 would have a purchasing power of £97,000 after one year on deposit. That is a £3,000 loss in our view.
How can you help?
A key element of what we do for clients is establishing how much risk they are willing to take and can afford to take. We then recommend our clients invest in line with this. Doing so ensures they do not over-expose themselves to riskier investments such as equities, especially if the potential losses involved could harm their standard of living.
Another area where we help is making sure the portfolios are well diversified. ‘Don’t put all your eggs in one basket’ applies here. Spreading the money across many investments might minimise the impact of any single loss. If those investments are in one type of asset, such as company shares, an event could affect them all. While share prices could fall, it is unlikely it would cause the value of all assets classes to fall. Each one reacts differently to the same political or economic event. We advise clients to spread investments across a range of different asset classes. These include (bonds, property, cash and alternatives). Doing so reduces the chance of losing money in absolute terms. If one type of investment loses money, gains elsewhere should offset this.
A diversified approach should reduce market declines, but it will not get rid of them. When a decline happens, we believe staying invested is the best option. Staying invested means not missing out on the rapid recovery phase, which usually follows a downturn. These are the ‘best days’ we covered earlier.
Financial planning comes into its own during market declines. We keep our clients focus on their financial plan and stay the course. We help our clients understand everything going on is typical and expected. As it has in the past, it will pass.