or should that be a Harry introduction….?
How do investments really work and what are the risks?
Investors are confronted with a bewildering range of ‘things’ or ‘places’ where they can put money. The idea of money is in itself a fiction – its value depends on a system of trust that can break down or even just be cancelled by the powers that be. You would not get much in return for a 5 Franc note or 10,000 Italian Lire now, apart from perhaps a bemused look, because the convention about what counts as money was changed and everyone in France and Italy just had to accept that. The fact that money is a concept, not a real utility makes it difficult to understand how it can be stored, or how it can grow – in a sort of magical way.
History
NotHarry remembers the quote that “history does not repeat itself, but maybe it rhymes” so often studies what has already happened to get some insights.
What to do with money is not a new issue. Anyone with a basic knowledge of the New Testament will remember the Parable of the Talents or Gold Coins as it is rendered in more modern Bibles (Luke 19: 11-24). This is not the place for a discussion about religious meaning (that is available only on special request!) but it always struck me as rather interesting when I was a young boy in a C of E primary school that Jesus could suggest that one servant could multiply the capital he was given 10 times, one 5 times and perhaps more obviously the one who kept his cash in his pocket (or equivalent) was severely admonished for not putting it in the bank to get some interest! Th0se were the days when you actually got interest on bank deposits!
This was in fact my first ever lesson in financial planning and the concepts of risk and reward, not to mention the idea of good bonuses for clever investment managers! I may not have taken the correct Christian meaning, I know!
I mention this to specifically draw attention to the fact that in our society you do have the opportunity to make more money from a stock of money you are not using, thanks to the principles of capitalism. All investments, however they are packaged – and the variety of packages is many and varied – and whatever they are called, are supposed to pay you something back that is more than you started with. That is because you have given up the use of the money so that someone else can have it. Economists call that “opportunity cost”.
What to invest in?
You might let someone have your money for a period of time with fixed conditions saying you can have the money back at an agreed date plus some specified extra (interest) fixed by contractual terms. That is called a loan or bond if the money goes to a business or public body, or if the deal is with a bank, a deposit.
Or you may buy the second-hand rights (from a stock market participant) to some unspecified future but hopefully increasing returns (dividends) and the option to sell on those rights. That entitlement is a share or equity. You can buy shares one at a time, or in blocks called funds.
One other option is to actually buy something you can rent out to be used, like a house of office block. That is obviously a property investment.
That is basically it, assuming you do not want to use your money to run your own business or speculate in trading assets that have unpredictable values, like art, wine, classic cars or Bitcoin. Note that cryptocurrencies are not yet investments but are tradable commodities where the price only depends on supply and demand from other collectors.
Very simple?
So to summarize, you can lend your money and have bank deposits or loan stocks/bonds, you can buy second hand securities with hopes of a growing stream of dividends and maybe a capital profit if you sell them on, or you can buy property to rent out. That is it.
Every sort of investment asset, however complicatedly contrived, “sliced and diced”, guaranteed, made available and so on is built on those bases. It must be that way, because capitalism only works if people stick to agreed sets of rules and trust the system, so everywhere in the world, including these days even in notionally Communist countries, people get interest on loans, dividends from shares and rent from property.
But at what risk?
Now we know that there are only very few “asset classes”, it is easier to work out things like the risk of losing your money.
If an investment asset is a bond (we now know that is a loan to a company or public body), the risks are that you won’t get your interest paid, you won’t be able to get your money back before the end of the loan term unless you can sell the loan on to someone else and you may not be repaid at all if the borrower goes bust. Note that the risks are actually the same if your borrower is a bank (you have a deposit account), although in many countries you may benefit from some State guarantees.
If the investment asset is a commercial property, the risks are that no one wants to rent it out, your tenant can’t or won’t pay the rent and that in a recession you can’t sell it, so it is totally illiquid (your money is locked up).
If the investments asset is a share that you bought second hand in the stock market, the risk is that no dividend is paid because the company is doing badly, so no-one wants to buy those shares and the price goes down and you can only sell for less than you paid if you want to disinvest. Worse still, the company goes bust and as that means no dividends in the future and the company probably has no net assets, you lose all your money.
Packages
The packaging up of lots of investments into products like collective funds (OEICS) and life assurance bonds allows these risks to be spread because in such packaged products you get to own part of a big fund of lots of loans, shares or properties.
Mixing funds investing in different types of assets allows further diversification of risk. There is evidence that mixing asset classes intelligently adds to long term investment returns and lowers the risk of loss. Noble prizes for Economics have been won by Professors who worked on the theory of how that is best done. At NotHarry, we are not aiming so high, but other articles will explain the basics of asset mix diversification.
As an aside, the way the returns on investment assets are taxed is not very logical nor is it consistent in many countries, so that keeps a whole industry of financial and tax planning experts in work!