The 3 Flavours of Investment Risk

This post was first published in September 2019 and updated in December 2020.

Most people think that investing in the stockmarket is dangerous. This is not really true.

Catching Ebola is dangerous. Juggling chainsaws is dangerous.

The stockmarket just contains some risks that you need to know about.

And if you buy and hold a low-cost global index tracker then you just side-stepped most of the risks.

There are 3 kinds of investment risk:

  1. Inflation and loss of purchasing power (the Ice Sculpture)
  2. Permanent loss of capital (the Turkey)
  3. Volatility (the Rollercoaster)

Let’s take a closer look at each of these…

1. Inflation

Do you think that cash is safe and the stockmarket is dangerous?

Wrong. Your cash is like an ice sculpture at a party. You can’t see it melting away…but it is. Inflation guarantees that your cash will lose its purchasing power over the long term. 

ice

With 3% inflation and 0.5% interest rates, you are losing 2.5% a year. That means your cash loses HALF of its value every 29 years or so.

Safety is relative. And total safety is an expensive illusion.

2.  Permanent Loss of Capital

Real risk is the permanent loss of capital…its where something goes down and it ain’t going back up again.  Like The Titanic for example.

Many investments look safe and predictable but the risk is swept under under the carpet. For example, P2P lending, high yield bonds or emerging market debt combine an obvious but limited upside with a hidden risk of total wipe out.

Take those P2P lending platforms that offer you ~10% interest (at a time when safe savings earn ~1%).  For years, I’ve been saying that P2P is mostly sub-prime lendingIn other words, the sort of thing that led to the last financial crisis. Recently we’ve seen Lendy go pop, Funding Circle wobble and that’s before a recession that would really spike loan defaults. 

Investors in P2P Lending are like turkeys on a farm. They get fed…until the game changes.

Financial independence

3. Volatility

Share price volatility is just numbers going up and down on a screen and, most of the time, that doesn’t mean anything…its mostly noise rather than signal.

Many people think that property is safe just because they can’t see the price going up and down. But what if we put an electronic ticker-tape at the top of your house and each time an estate agent or property developer walked past, their guestimate of value was shown as a price? Result: price volatility but no extra real risk.

Owning shares means you own a slice of the real economy. You share in the abundance created by technological progress.

Owning a slice of the stockmarket is simple. Just make sure that you are never a panicked / forced seller of shares in a bear market. Stockmarket volatility is like a rollercoaster. If you stay strapped in, its just harmless fun. But if you get out halfway through the ride, it’s very dangerous. I know because I’ve been that guy. 

Bear markets are the friend of the long term investor.

If your supermarket temporarily marked everything down by 50% you’d respond by stocking up. Why should stockmarket investing be any different?

Answer: it shouldn’t. If you are a net saver (and if you’re reading this website then you probably are) then you should be hoping for the stockmarket to fall so that you get more units for your money every month.Yes I can prove that. This table shows the benefits of drip-feeding money into a volatile market that feels uncomfortable) compared to a smoothly rising market (that feels better).

The lower the index level at the time of investing, the more units each £ / $ buys and so the more shares in real businesses with real assets the investor ends up owning.

The investor’s portfolio ends up worth more in a flat, volatile market…even with a price level 28% lower at the end of year 5,.  And the difference in the number of shares owned is striking. The investor in the flat, volatile market ends up with 42% more shares.


I was reminded of this when talking with Andy Hart on The Maven Money podcast. You can watch the investing section of our discussion here:

The Escape Manual is explained * here *

9 comments

  1. Love it. Just started investing this year, in my early thirties. Have already seen the market move both ways, and the advantages of drip feeding monthly are evident. Great to see this as reassurance also.
    Hoping someone with more investment knowledge could advise if the following set up is suitable for a long term investment strategy? Thanks for any advice!!

    One third – LifeStrategy® 100% Equity Fund – Accumulation
    One third – FTSE All-World High Dividend Yield (VHYL)
    One third – U.S. Equity Index Fund – Accumulation

  2. Dude – you’re wearing the “Stoicism” Shirt I designed – THANK YOU for the purchase! And I love the analogy of making the “marathon” of FI shorter. In every marathon I’ve run, when you get to that 21 or 22 mile mark that’s when the pain gets real. Wouldn’t it be great if it ended there…

    Great post, cheers

    1. Seriously?? You designed the stoicism T-Shirt?? That is absolutely brilliant 👏

      1. I did indeed. And I have about 30 or 40 more FIRE-inspired designs that can be found on my blog, but not gonna be spammy with a link. Great job on that podcast!

        1. Dude, FI people need clothes too…HERE IS THE SITE (no affiliate link!)

          https://accidentalfire.com/fire-lifestyle-designs/

  3. […] And discusses risk, with a link to his Maven Money appearance (31) […]

  4. Great post.
    I was reflecting recently that my mother and father have invested in cash savings over the years and would have been considered very risk adverse.
    If they had have invested in a simple tracker then they would have made millions or at least a significant amount more than what cash has delivered.
    On the other hand, investment outcomes for most retail investors have been far from great over the last 40nyears and they would have just paid a fortune in fees.

    The general public are ignorant of financial choices and are often swindled which is why so few people have isas and most are modest in size and the UK has a fondness for bricks and mortar investment which has its own implications and for all the money poured into property it hasn’t delivered much by the way of technologically led economic growth.

  5. A very long period of underperformance is a real risk, too. The FTSE is LOWER in nominal terms today than it was 20 years ago.. that is a long period of medicore performance in return for holding a risky asset class.

    You may counter this by saying that’s why you should hold global stocks.. to which I will counter-counter by saying that 20 years ago the FTSE’s track record was just fine, and therefore nobody saw the need to diversify internationally and it was normal practice to invest wholly in your local stock market… even today many UK investors have limited international exposure.

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