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Investing for beginners: Risk, returns, time, and diversification

Time is a critical factor when considering risks and rewards [1] in investing.

Does this look like a good investment [2]?

great-crash-of-1987-UK-graph [3]

This graph shows the great stock market crash of October 1987. London’s largest companies lost one-third of their value in just a few days. How would that feel?

Here’s what happened over the next five years:

after-great-stock-market-crash-1987 [4]

The big crash is still visible, on the left hand side of the graph, but UK shares had recovered back to pre-crash levels just 18 months later. The stock market then went basically nowhere for the next three years.

In this case, the best time to invest was when it felt worse – right after the crash [5]!

Past performance is no guarantee of the future, but we can’t ignore its lessons.

Today the Great Crash of ’87 barely registers on this three decade graph of the FTSE 100:

ftse-100-long-term-graph [6]

So do markets always come back if you wait long enough?

Investors in Japan in the late 1980s have not been so fortunate:

nikkei-225 [7]

More than 20 years later, the Japanese index is still roughly two-thirds off its peak. How long is their long term?

Let’s consider a different case. Does this look like a good investment?

UK-gilts-post-2008-to-2012-graph [8]

This graph shows the progress of a UK gilt fund between 2008 and the start of 2012.

Gilts [9] – UK government bonds – are the safest investment after cash [10] for UK citizens. So a fund invested in gilts should do well, right?

Well, here’s how the same gilt fund has done since the start of 2012:

gilts-2012-2013-graph [11]

Investors in this less risky fund have lost money, even after reinvesting all the income from gilts.

And here’s how the gilt fund has done from 2012 compared to UK shares:

gilts-vs-shares-graph-since-2012 [12]

Since the start of 2012, the ‘safe’ gilt fund (blue) has fallen in value 3%, while the ‘risky’ FTSE 100 (red) has increased 15%. (Aside: shares have been more volatile.)

I am not making an argument here for shares versus gilts, or vice versa. This is just an example.

Any investment must be considered over different time scales, not just the past month. ‘Safety’ is relative, and depends on valuation. Things can go down and bounce back, or stay down.

Time and diversification

We don’t have a time machine, and we don’t have a crystal ball. We cannot invest in the past with hindsight, and we cannot be sure of tomorrow’s winners.

But we can spread our risk among different kinds of investments (assets).

By holding a collection of assets we can smooth out the ups and downs, and maybe turn that volatility [13] to our advantage!

Different kinds of investments – like cash, bonds, property, and shares – are called asset classes. For example, cash is an asset class. Barclays shares are a specific investment within the asset class of shares.

Here is a typical spread of returns from six different asset classes over an illustrative decade-long period:

investing-lesson-six-assets [14]

It doesn’t matter what the different assets are here – this is just an example.

The important thing to look at is the shape of the graphs, and the numbers in the following table.

Asset Total Return Annualised Worst year Best year
A 34% 3.3% 1% 7%
B 48% 4.5% -7% 8%
C 80% 6.7% -16% 19%
D 165% 11.4% -21% 57%
E 36% 3.5% -6% 8%
F -6% -.7% -22% 20%

Note: Numbers for illustration only

Where:

In this series of returns and graphs we can see that:

Why pick one when you can have them all?

If we had that table in year one, then we’d have put all our money in Asset D and made a fortune.

But we won’t and never will. We can’t be sure about the future. As for being guided by the recent past, if anything, the best asset over the prior ten years is more likely to do relatively worse over the next ten (but no guarantees!)

What if we hedged our bets and split our money across all six assets in year one?

Here’s how things would have turned out after a decade.

  Total Return Annualised Worst year Best year
Portfolio 59% 5.3% -3.5% 14.7%

Note: Numbers for illustration only

What if we tried to take advantage of the volatility, by trimming our winners and adding to the poor performers every year?

As a simple illustration, here’s what happens if every year we sold everything and then reinvested our money again, equally split between the six asset classes:

  Total Return Annualised Worst year Best year
Portfolio 61% 5.5% -3.6% 15.4%

Key takeaways

This is one of an occasional series on investing for beginners [17]. You can subscribe [18] to get our articles emailed to you (we publish three times a week) and you’ll never miss a lesson! And why not tell a friend [19] to help them get started?

Note on comments: This series is for beginners, and any comments should reflect that please, rather than confuse or make irrelevant points. I will moderate hard. Thanks!

  1. i.e. After nine full years of investment [ [21]]
  2. Volatility describes how often or how far an asset goes up and down [ [22]]