Is Investing In The Share Market Too Risky?

posted on April 4th, 2012 by Bellmont Research Team

Have you recently come into money? Maybe you have sold your business, received a large inheritance or perhaps you have just set up a Self Managed Super Fund (SMSF) you’re probably wondering what is the right investment strategy. Every day we see headlines about property prices and share markets retreating, we see the interest in our savings account diminish as rates are lowered and we ride the wave of investing emotion with the 24hour news cycle that is constantly in front of us. Since 2008 the world financial system, and in particular share markets, have experienced the dramatic shocks of the GFC and European debt crises leaving many people asking if investing in the share market too risky?

Before answering this question it is important to understand what risk is and how this affects our investment decisions. Risk exists when there are multiple outcomes to a situation. The risk is the uncertainty of what the final outcome will be. When it comes to investing the risk is whether the desired financial result is achieved. Risk is a combination of two aspects, Risk Tolerance and Risk Capacity.

Risk tolerance is how willing someone is to accept a negative outcome in the pursuit of a more favourable result. Risk tolerance is purely psychological and is shaped by a person’s past experiences, attitudes, age, gender, education, their family and friends, and other outside influences.

Risk capacity is more black and white, it is a measure of the amount of risk an investor can afford to take to reach their financial goals. An investor’s risk capacity is limited to their assets, liabilities and income.

It is important to understand that one area of risk is emotional and psychological while the other is not. Our emotions are easily swayed by our day to day experiences, what we read in the paper, what we see on the news and numerous other external factors. When it comes to investment decisions, emotions are easily influenced by the current environment. If the news about the economy is negative then generally people’s emotions are also negative which leads to a lower risk tolerance; and conversely when media reports and general economic sentiment are positive, the investors’ risk tolerance increases. The problem with this is that when it comes to investing our risk tolerance should be inverse to our emotions, that is when economic sentiment is negative and asset prices have plummeted this should be the time when we have a high risk tolerance and when asset prices have escalated we should have a low risk tolerance. Let me explain with a day to day example and an investment scenario.

Let’s say you are in the market for a new TV, you have done your research and you know the exact make and model you are after. You walk into shop A and they are selling the TV for $1,000, after which you walk into shop B and they are selling the exact same TV for $800. Naturally you will buy the TV from shop B as you are getting the same TV for better value. This is a fairly straight forward concept that almost everyone would agree with. Let’s now look at two similar investment scenarios.

Scenario one: You want to invest in the share market, you have done your research and you wish to invest in the company XYZ which is currently trading for $10. The share market has been performing strongly it has moved 15% higher over the last six months and everyone is feeling positive about its future prospects so you decide that you are happy to take on this risk and you buy XYZ shares at $10.

Scenario two: XYZ is a company that you like and it is currently trading for $8, however everyone is very downbeat about the share market, it has fallen 15% in three months, and your emotions are telling you that everything is very negative and risky so you decide not to buy, you would rather wait for confidence to improve.

In these scenarios you have exactly the same company XYZ, in scenario one you can buy it for $10 and in scenario two you can buy it for $8. Most investors behave like the example in scenario one, they are happy to buy the company for $10 because everything seems fine. However in scenario 2 you can buy the exact same company for only $8. It is important to understand that a stock price reflects two things, the business’s earnings and sentiment (general feeling about the share market). Since companies only report earnings twice a year the remainder of the time a stock price is driven by sentiment, sometimes the sentiment is positive other times it is negative, either way the true value of the business is often overlooked as sentiment becomes the main driver of the stock price. Let’s also examine the risk between the two scenarios if you buy XYZ at $8 you have a lower risk profile than if you bought at $10 as your maximum downside is $2 less. Like the example of the TV, we can all agree that buying it for $800 is a better outcome than buying it for $1,000; this same principal should apply to our investments.

When the share market is strong and prices are increasing people get caught in the positive euphoria and decide that it is a good time to buy, and when sentiment is negative and prices are falling buying is furthest from people’s minds. So is investing in the share market too risky? There is always risk when investing in any asset and the share market is no exception. However if you have the right strategy and have an understanding of risk and how emotions effect your investment decisions then your next question should be is it riskier to buy XYZ at $10 or $8?

Simon Bylsma – Investment Adviser at Bellmont Securities

This article was written for the Peninsula Living Magazine and will be published in their April 2012 edition

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