As a reader of The Daily Reckoning, you’re well aware that investing is not risk free. You only have to look at the performance of the ASX — or any of the world’s other stock markets — this year to verify that.
That’s why all of our editors of our premium publications take the time to highlight the specific risks with every recommendation they give you. And point out that you should never invest more than you can afford to lose. It’s also why you should never invest more than a small part of your wealth in any single investment.
Of course, often our editors’ recommendations do end up seeing large gains. Making you wish you had invested more than you safely could! But that’s the same kind of hindsight thinking that has me wishing I’d bet ten grand on Prince of Penzance in the Melbourne Cup.
What defines risky?
I bring up the issue of risk because the Australian Securities and Investment Commission (ASIC) may soon require warnings to be placed in the product disclosure statements (PDS) of ‘risky investment products’. That’s all part of the new powers ASIC is likely to be granted in a rather belated effort to clean up the financial industry.
According to The Australian Financial Review:
‘A host of complex and risky financial products could have investor warnings slapped on them, in the same manner as the graphic warnings on cigarette packets, under new safeguards being considered by the corporate regulator.’
Now it’s certainly not a bad idea to give investors the heads-up about potential risks. Although in my experience, a proliferation of warnings generally leads people to start tuning them out.
But two things really jumped out at me.
First, the comparison to graphic warnings on cigarette packs. I’m sure you’ve seen these. Can you imagine something similar on the PDS of a futures contract you’re about to invest in? Maybe an image of a harried investor, tie half undone, standing on the ledge of a tall building. And the caption, ‘Warning, investing can be hazardous to your health.’
Second — and more seriously — is the fact that these warnings will be placed only on what ASIC perceives as risky investments. What they’re missing here is that every investment comes with risk. Even cash isn’t 100% safe. To begin with, your cash returns these days are minimal — often less than inflation. And if your deposit exceeds the Australian government’s $250,000 deposit guarantee, you could lose all your cash in excess of that amount if your bank goes under.
Given this, ASIC’s planned warning labels may do more harm than good. That’s because you may be falsely led to believe that an investment without a graphic warning must be safe.
Seeking a safe haven
Blue chip stocks are a good example. It surprises me how many people are willing to overextend themselves in big blue chip companies. For some reason they see these multi-billion dollar companies as safe havens. And they’re willing to punt 10% or more of their wealth on a single blue chip stock.
That’s a mistake.
While historically blue chips — as a whole — are less volatile than small-caps, they are not immune to economic slowdowns, competition, changing market dynamics, or poor choices by management.
Take Woolworths [ASX:WOW], for example. With a market cap of more than $30 billion, it certainly counts as a blue chip. And with most of its revenue derived from consumer staples — items we need every day — you’d expect a rather stable performance. Yet the stock is down 30.8% since this time last year.
And BHP Billiton [ASX:BHP] has a current market cap of $86.3 billion. On Friday it was down 3% for the day…and 42.4% since this time last year. Just to break even on the money you invested in BHP last year, you’d need to make a 73.6% gain on your remaining investment. Not many blue chips companies will give you those kinds of returns in a hurry.
In case you’re thinking I chose these two just to make my point, let’s dig a little deeper.
Have a look at the chart below. It shows the performance of the ASX 200 (that’s the largest 200 listed companies) since the start of 2015. The results? The index is down 3.56%.
Source: Yahoo Finance
Now look at the following chart. It’s the ASX Small Ordinaries, comprised of the smallest companies.
Source: Yahoo Finance
As you can see this index is up since the start of the year, by 1.66%. Now that’s not a blistering return, but it’s 5.22% better than the large-cap stocks offered.
Obviously this won’t always be the case. But it does highlight how hard it is to pinpoint risk at any given time for any given investment.
Speaking of mitigating risk, I had the pleasure of spending a few days with our wealth preservation expert, Vern Gowdie, last week. You may know Vern from The Gowdie Letter, or his premium service, Gowdie Family Wealth. If so, you’ll also know that Vern spent many years as a financial planner.
Vern was recently in Melbourne for editorial meetings with the rest of the Port Phillip Publishing editors. Today I’ll just mention one thing Vern said that you won’t hear from many, if any, financial planners. About 18 months before the ASX began to crash in October 2007, Vern saw the writing on the wall. He took a highly conservative all cash position and advised his clients to do the same.
Some listened, and they were spared the 50% loss the market suffered over the next 14 months. Others weren’t happy keeping their cash on the sidelines. In fact, three of his clients insisted that he offer them stock tips or they would take their business elsewhere. Despite losing fees of around $25,000 from each of these three clients, Vern stuck to his guns. He refused to advise them to invest in any stocks.
These are the kinds of principles the financial planning industry could use more of. The kind of principles that would negate the need for graphic warning labels showing investors in ragged clothes, holding bake sales in an attempt to pay the mortgage on their negatively geared property.
Here’s what Vern wrote to subscribers of Gowdie Family Wealth in his November issue:
‘Thinking a little deeper and for a little longer can potentially save you a world of financial and emotional pain.
‘A friend contacted me recently about a mutual acquaintance who lost around $11 million in a failed investment. It was nearly all his life savings. He focused on return and did not do sufficient, if any, due diligence on the risks.
‘Sadly, his family’s wealth was made and lost in one generation. And from what I hear the family is struggling to cope with the loss. “How did this happen? Why did you do it? Didn’t you look into it deeper than that? How are we going to pay our children’s uni expenses?”
‘This is not the conversation you want to be having around the dinner table, and these are not the thoughts you want to go to bed with.
‘Second level thinking may have saved that family from the heartache they are experiencing.
‘At the risk of sounding like a broken record, there are three parts to wealth — creation, retention and promotion. There’s definitely one part you don’t want — destruction.’
If you haven’t checked out Vern’s work yet, you can find out more about Gowdie Family Wealth here.
Managing Editor, The Daily Reckoning