If you want to attract retail investors to a new offering, two words that invariably help achieve that are ‘low risk’. Even though most people would probably, if pressed to explain what they mean by the term, come up with a range of different answers, almost nobody likes high risk if offered the option of either that or low risk. This is no doubt a function of human evolution, as the early humans who took a risk with a predator were less likely to survive the encounter and therefore to pass on their genes to subsequent generations.
Unfortunately the widespread preference for investments with low risk means that any charlatan or chancer who wants to attract investors to their shiny new investment product only has to make it sound low risk and they can be fighting off applicants with a stick. A few years ago I was involved in a court case about what was ultimately shown to be a highly speculative investment venture but which was portrayed to the unsophisticated private investors who ended up funding it as low risk. This was despite the issuer of the securities describing them in the offer documents as ‘high risk’ but as there was no evidence that the investors were shown these, instead they went by what they were told by those who were ‘advising’ them and who were heavily incentivised by the issuer to promote the scheme.
I had never heard of Bernie Madoff before his fraud was exposed but a large part of his appeal to the investors that were taken in by his fraud (including some professionals who really should have dug a little deeper before committing their clients’ assets) was that his fund’s returns were very consistent from year to year and therefore it was low risk. Over the years I have had several other ‘opportunities’ punted to me by product providers as low risk and most of them subsequently blew up and took investors’ cash with them. What is especially galling is that having avoided them because they looked dubious, the cost of compensating those who lost out falls onto the surviving firms.
The fact that fraudsters like to describe their offerings in these terms should not lead us to think that all such offerings are fraudulent. However, that does not mean that they are all suitable for the unwary investor. Some entirely legitimate investments that can appear to be low risk (because their quoted price changes over time are small) can carry hidden risks such as a loss of access due to infrequent trading, lack of a functioning secondary market or contractual penalties which deter investors from withdrawing their capital. The latter was particularly endemic in the 20th century but fortunately regulatory pressure has seen off the worst examples of the practice, at least in regulated markets; offshore, not so much.
I find that a good starting point when assessing the actual risk of a ‘low risk’ investment is to compare the offered return with that available from a UK government gilt with a similar term to maturity. If the gilt is paying 3% over the next 10 years, then that is the rate the market expects for lending to an institution which can literally print its own money to meet its obligations. If an offering from another institution (which lacks that facility) is offering 9%, it’s probably something like three times as risky because no issuer will offer to pay investors 9% if it can raise the money from them at a lower cost like 5% or 6%. Since there can be no low risk investments which offer a high return (demand would be so high that the price would rise and the return would fall), this method always seems to work, at least as an initial filter.
A lack of understanding of risk also makes us prone to focusing on the wrong risks. We perceive that investing, particularly in shares, will result in a reasonable chance of a total loss. Stories of large corporate failures, whether they be large banks, financially-engineered energy companies, hedge funds or household names on the high street, remind us that even being large or well-known or having a long history is no defence against failure. In fact over long periods of time, most businesses fail, as they are outcompeted by others. However their place is taken by new businesses and investors’ capital is redeployed to those, which is how capitalism works. This is why we say that investors should invest in capitalism rather than in specific companies. That means spreading money across a large number (hundreds and preferably thousands) of companies, many of which will be largely unknown (even though it was founded in 1993 and how many people, apart from buyers of its graphics cards, had heard of NVIDIA until a couple of years ago?) and will remain so. Nobody can reliably identify which of them will be successful and which will not so by holding all of them, investors increase their chances of riding the trend over time and building wealth relatively slowly.
Of course, getting rich (or at least avoiding becoming poor) slowly is a difficult story to promote. It doesn’t make you look like a genius and it doesn’t provide much a conversation point with your friends. But it is much simpler than doing it quickly and as Warren Buffett says[1],
“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person. Your capital is at risk when investing. Past performance is not a reliable indicator of future results and forecasts are not a reliable indicator of future performance.
[1] Graham, Benjamin, The Intelligent Investor
