I was reminded recently about the investment risk of buying shares in individual companies rather than leaving the decision up to an investment fund manager.
I was speaking to my friend who last year bought shares in an up and coming technology company which is listed on the Alternative Investment Market (AIM) . He had done his research, felt the company had excellent prospects and bought the shares at a price he felt was reasonable.
Over the last 6 months he has been singing the praises of this company as its share price rose 50%. Then all of a sudden he has seen the share price fall 32% as a result of some damning reports of misleading accounting.
I have also discussed with another friend recently how his friend has held shares of a famous UK bank for years after receiving them as part of a share save scheme when he worked for the bank. He has held them when the share price was at its height, and continues to hold them to this day as banks try and recover from the banking crises and subsequent huge falls in share prices.
Both these investors would have seen the value of their investment rise tremendously and then see it tumble back down.
What we are seeing here is the massive increase in investment risk and volatility (the variance in investment returns) that comes with picking individual companies to invest in.
Reasons why people take this type of investment risk
When I say there is an increase in investment risk, I mean this when compared to the alternative of buying units in an investment fund which will be invested in 50 to 100+ companies.
When buying shares in individual companies the extra investment risk comes from the fact all your eggs are in one basket. You are wholly reliant on that one company doing well and continuing to grow its share price. There are more and more companies going bust all the time as the world and our tastes change. It only takes one bad piece of news or government regulation and the share price of a company can seriously fall, perhaps even to the point where you lose all your money.
So why do people take the extra investment risk?
#1 – Potentially bigger rewards
- When it comes to investing risk and reward go hand in hand.
- You can’t make greater investment returns without taking greater risk.
- Although taking extra risk there is no guarantee of achieving greater returns.
#2 – Excitement and interest
- Some people are big fans of the company they invest in so want to follow and be part of its progress.
- They like to gamble and get excited by the big rises in share price.
- Both NOT good reasons to invest!
#3 – Follow the crowd
- Fear of missing out.
- Trust their friend’s ‘advice’.
#4 – It’s what they know
- If you’ve worked for the company and received the shares as part of your employment there’s a chance you will feel you know the company better than others.
- You remain loyal to the company.
There are many other behavioural biases that come into play especially when it comes to the decision on when to buy and sell a share. I shall cover some of these another time.
How to protect against this type of investment risk
So in spite of the increased investment risk that comes with picking individual companies, there will always be people that want to do it and there is nothing wrong with this as long as you are clear in what you are doing.
If you have yet to make up your mind as to whether you want to take this extra investment risk consider these points:
If you plan to hold shares in a number of different companies and actively manage your portfolio then you will likely incur high costs for buying and selling shares. These costs will eat into your overall return.
A large portfolio required to reduce investment risk
In order to reduce the investment risk of holding all your eggs in one basket, (choosing one company) you will need to pick lots of different companies so if one goes bust you don’t lose all your money.
Do you have the time to manage your own portfolio? Are you in a position to make decisions quickly after extensive research when a new piece of news is released which has the potential to affect the share price?
Can you be certain you will be right all of the time or even most of the time?
You see, investing is a zero sum game. For every winner there has to be a loser. Another way of saying that for every buyer of a share there will be a seller. You both have access to the same information. So who is right and who is wrong? It is very very difficult to be right all the time and sometimes your successes will just be down to luck!
An alternative approach is to diversify your investment into investment funds that invest in a range of different assets (shares, property, bonds) in different areas of the world so that the actions of one individual company has hardly any effect on your overall portfolio.
Even better is to avoid active fund managers who try to outperform the general market. As I have mentioned previously, investing is a zero sum game and even the managers don’t get it right consistently, especially after you factor in the extra costs they charge. The evidence points towards passive tracker funds as a much cheaper and smarter way of investing. Please give us a call so we can discuss how you can benefit from smarter investing and don’t forget to download our ‘Simply Investing’ guide below which provides further information on how to reduce your investment risk.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.