What caught my eye this week.

New research from Scottish Friendly makes dispiriting reading for anyone who has spent a decade trying to teach people about investing.

(*Looks around room* “Who me? No no, I was in it for the Brexit banter.” *Shuffles away*)

It seems that having surveyed 2,000 UK savers, the life assurance giant has discovered half of us are afflicted by what it calls ‘investophobia’.

Scottish Friendly says:

• Inflation is currently running at 2.4% yet the best easy-access cash savings rate available is 1.33%.

• Almost two-thirds (66%) of savers are aware that interest rates on savings accounts are less than the current rate of inflation.

• Despite that, more than half (53%) of UK savers say they wouldn’t consider investing in stocks and shares.

• Almost half (49%) say fear of potential losses is the main reason holding them back.

A decade ago, many web explorers who wandered into Monevator Mansions had sworn off shares forever. We seldom see such people anymore.

Ten years into a bull market, we – and often many of you, in the comments – are mostly reminding visitors that bonds, cash, and property still have a place in their portfolios, let alone that it’s not a great idea to go all-in on, say, tech stocks or emerging markets.

Yet out there in the wider world, the majority still wouldn’t touch a share with a barge pole.

Small mercies

Messing about with the tools at Portfolio Charts suggests that a UK saver who kept all their money in cash would have seen an average annual real return of about 1.6% since 1970. Standard deviation was 4%.

Remember ‘real’ means these are inflation-adjusted returns. Cash can lose you money when inflation is higher than the interest rate you’re paid. The tool suggests that happened in 31% of the years.

So what happens if we take a stiff drink and put a modest 20% allocation into global shares, while still keeping the rest in cash?

Mostly good things. The average real return rises to 2.6%. Standard deviation is only modestly higher at 5.1%. And the number of money losing periods actually fall from 31% to 27%, despite the inclusion of risky shares.

That difference between a 1.6% average real return versus 2.6% isn’t much on paper, but it’s significant over time.

A compound interest calculation reveals:

• Over 30 years, a 1.6% return turns £100,000 into £160,000 on a real money basis.1

• A 2.6% return takes your wealth to £216,000 over the same period. That’s a significantly better result, with only a little more volatility and fewer outright losing years.

Of course you and I know that on a 30-year basis, having 80% of your money in cash is very sub-optimal.

• For the record, a simple 60/40-style portfolio split between global equities and intermediate UK government bonds chalked up an average annual real return of 5.3%, albeit with much higher volatility. That’s good enough to turn £100,000 into £471,000 in real terms.

Adding other asset classes can tweak the return profile further.

Here’s one I did earlier

So yes, agreed, having just 20% of your money in shares is far from perfect.

But remember, we’re not look for a home run here – we’re just looking at getting people off a terrible first base with their 0% allocation to the stock market.

And here simple – if sub-optimal – strategies can make a big difference.

I’ve mentioned before that I’ve often started friends investing with a 50/50 allocation split between shares and cash. (Now I’d probably favour a Vanguard Lifestrategy 60/40, unless they really insisted on seeing and cuddling the cash).

Nobody around here is going to suggest having 50% of your investment in cash is ideal. But I’ve seen it change lives.

For instance, a friend of mine – who was running a persistent overdraft when I first met her – agreed to try something similar to this and to start investing back in 2002 or 2003.

To supplement her work pensions held elsewhere, she began direct debiting money from her paycheck every month, splitting it between savings and an ISA stuffed with index funds.

At some point around the financial crisis she meddled without telling me, diverting some equity money into more expensive self-styled ethical funds. But besides that moment of madness/enthusiasm, she basically ignored the portfolio. She only rarely increased the contributions. Most annual statements went unread into a bottom drawer.

She still enjoyed a good result. In fact a couple of years ago she called to thank me for getting her started.

This painless strategy had compounded over 15 years into a significant six-figure sum – a deposit for her first flat, in fact!

I’ve visited her new family’s home in London, and it’s lovely.

The only way is up

Perfect can be the enemy of the good, as my old dad used to tell me. I wouldn’t attempt to turn anyone into The Accumulator overnight.

Know somebody terrified of shares? Try to get them to set up a direct debit to put say £100 – or whatever is a small but meaningful sum for them – into a global tracker every month.

Chances are after a few years they’ll catch the bug and lose their fear. Then they’re off!

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1. i.e. The spending power of £1 remains the same. [↩]

What caught my eye this week.

A few years ago the Financial Times published an article about students and money that caught fire and went viral.

I can’t even remember whether the gist was eat fewer avocados or mount the barricades and challenge the system. But I did notice it seemed to lead to a change in editorial tone.

Perhaps it was a coincidence or a staff change, but the personal finance section (which I’ve been reading since I was a 20-something myself) definitely took a lurch to the sympathetic. A cynic might say the FT was chasing new traffic it hadn’t known was there. I suspect it realized even its uniquely affluent young readership felt under the cosh.

Now, I know not every Monevator reader of a certain age has made that leap.

However personally I do believe – financially-speaking – that it’s tougher now for most aspirational young people than for many decades.

No, not tougher than it was for a miner’s son wanting to follow his father down the pit in the Valleys in the early 1980s – nobody is claiming that.

But far harder for an averagely studious young person to achieve averagely good grades and get a middle-of-the-road job and end up with a house and 2.4 kids on anything like an average street in an average town.

And at the end of the day, for most people for right or wrong that’s what it’s all about (including virtually all those older folk who say “let them eat rent!”)

Money saving experts

Anyway, all that’s a long-winded way of saying that the FT’s Millennial Thrift special this week has lots of tips on saving money, many with a digital dint.

Some even work if you’re an old lag like me. Especially as there’s a London slant.

Go check out all the tips at the Financial Times [search result], and if you’ve got any that aren’t mentioned then feel free to add them in the comments below.

(Let’s only have a couple of obligatory sarcastic Viz knock-off tips please! 😉 )

As to whether saving £8 on a movie ticket or getting a cheap pizza is a sustainable solution to homes priced at 20-times local earnings… well that’s a debate for another day.

Oh yes: Come on England!

[continue reading…]

The relationship between risk and reward is a cornerstone of understanding long-term investing.

As we saw in a previous lesson, the various asset classes – cash, bonds, property, equities and so on – sit on a continuum of rising risk and reward.

• Cash is the least risky asset class – it’s often considered risk-free – but you also expect the lowest return from it.

• Bonds are riskier, and over the long-term their historical returns have been higher than from cash.

• Equities are the riskiest mainstream asset class. They’ve typically delivered the highest returns over the long-term.

Remember that when we say ‘risk’ here, we mean volatility – how much prices move around – although the risk most of us care about more – losing some or all our money – also applies.

Another – non-academic – way to think about risk is it’s the probability of something being worth less than you paid for it at some point in the future.

Cash in a bank never goes down in value. Shares can fall 5% in a day and crash 50% in a matter of months in a bear market, though that’s rare. But over the very long-term the returns from shares can be expected to trounce cash.

Why does this relationship hold? Because it has to.

Why risk taking usually pays in investing

If you think about it, why would anyone invest in a riskier asset class if they only expected to get the same return as from a less risky asset class? (And the latter with better sleep and fewer grey hairs, too.)

The odd person might make misguided bets.

But the market as a whole is considered to be rational and efficient, not an Edward Lear poem.1

If a riskier asset class appears to offer only the same return as a less risky one, then something has to give. The price of the riskier asset falls until it is cheap enough to offer sufficiently enticing expected returns to make up for its extra volatility.

• Why would you put up with fluctuating bonds prices if you don’t expect higher returns than from cash?

• Why risk the vertiginous death swoons of the stock market if you only expect to earn the same returns as from more stable bonds?

• Zooming into specific shares, why invest in a risky start-up company if you only expect to get the same return as from an established blue chip?

In every case the answer is your expectation of higher returns.

In general the market does a good job of sorting out the pricing of various asset classes at any time to match buyers and sellers at the different risk/reward points.2

We investors can then bolt together portfolios from the different asset classes with the aim of matching our overall risk tolerance.

But here comes the important point. Academics – who came up with all this theory – warn that the relationship of more risk, more reward does not always hold.

In some circumstances you take greater risk, yet you can’t expect the market gods to reward your chutzpah with greater returns.

Academics call these lousy bets uncompensated risk.

Uncompensated risk: Just say no

The classic example of uncompensated risk is buying shares in an individual company versus investing in the broad stock market.

Let’s say you expect shares in financial blogging firm Monevator Industries to deliver a 10% annualized return over the next decade.

Suppose you also believe the wider stock market will return 10% a year.

Now, there are many quirky things that can go wrong with Monevator Industries on the way to you earning your 10%.

• It could suffer an industrial accident.
• Its products could go out of fashion.
• Its CEO could buy a new apartment and get distracted from running the business.
• It could go bust.
• At the very least its price is likely to move around a lot to reflect the market’s shifting assessment of these factors.

Of course, the stock market as a whole will also go up and down, too. Its various constituents will have their woes.

But all companies in the market should not suffer the same business disasters at exactly the same time.

If you’ve got all your money in one stock, you’re therefore taking on a lot more risk than the market – including the risk of losing all your money.

But don’t panic! Holding more than one company immediately diversifies your portfolio, and reduces this risk.

And the more additional companies you hold, the more the company-specific risk is diversified away.

Estimates vary, but holding as few as a dozen-to-20 different shares3 gets rid of the bulk of the company-specific risk. By the time you’re up to 50-100 different holdings you’ll have to hunt for the decimal point.

At the extreme you can just buy the whole market via an index tracker fund. Now you have diversified away all the company-specific risk. You’re just left with the risk of holding equities as an asset class.

Why uncompensated risk doesn’t pay

According to that academic relationship between risk and reward, a risk that can be easily diversified away cannot be expected to reward you with higher returns.

Why?

It goes back to supply and demand.

If investors can reduce the risk of investing in any single accident-prone company by holding a bunch of them, then the risk of investing in companies isn’t such a big deal, after all.

Investors therefore won’t demand so much extra expected return to entice them to buy. They’ll take lower returns and diversify.

Because the risk of holding a few individual companies can be easily diversified away like this and not be expected to give you higher returns, it is said to be uncompensated risk.4

As a consequences, you should not expect to earn higher returns simply from running a more concentrated portfolio of shares.

Note: I am not saying that you can’t make money investing in a single company’s shares. Clearly you can! You might have put all your money into Amazon shares at a few dollars and now be a multi-millionaire. Similarly, you might have lost everything in failed bank Northern Rock. In efficient market theory you can’t know which will happen in advance. You just know “shit happens”, and that you can diversify away the risk.

Another example is currency risk. This risk of currencies moving against you can be hedged away and the impact nets out over the long-term with a global equity portfolio, so it is considered to be another uncompensated risk.

Active management is a zero sum game that overall reduces returns to investors through fees and other costs. So some argue that it too is also uncompensated risk.

If you buy one fund, you might do better or worse than the market. The more funds you own – the more you diversify – the more that risk goes away.

Eventually this logic takes you back to owning a total equity market index fund, where you expect higher returns compared to a less risky bond fund, but no special extra returns on top.

Key takeaways

• Generally-speaking, you will only get higher returns by taking on greater risk.

• However greater risk cannot always be expected to deliver higher returns.

• Risk that can be easily diversified away is called uncompensated risk.

• The market doesn’t pay you for uncompensated risk.

• Index tracking funds that invest across broad asset classes are an easy way to diversify.

This is one of an occasional series on investing for beginners. You can subscribe to get our articles emailed to you. Why not help a friend get started, too?

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. Sometimes this efficiency breaks down, as behavioural economists such as Nobel Prize winner Robert Shiller have shown. But almost everyone agrees it’s big picture efficient most of the time. [↩]
2. Yes, it goes crazy sometimes and seemingly gets it wrong – such as when we see market bubbles. Again, that’s a discussion for another day. [↩]
3. Chosen from different sectors. They can’t all be sausage makers or umbrella factories. That’s not diversified. [↩]
4. You might expect to do better than the market because you believe you’re a brilliant stock picker, but that’s another – very unlikely – bet altogether! [↩]