Understanding the risk hierarchy

The lifespan of companies

When you look back at lists of the top companies from 20, 30, or 40 years ago, it’s nearly always remarkable how few of them are still at the top of the tree (or even around at all!) today.

But where do they all go?

Well, some get taken over by Aussie companies, others are bought by foreign businesses, some are merged, and many become worthless and are de-listed.

Source: Cuffelinks

Like you and me, companies have a lifespan.

They are born, they grow, then they fade away, and one day they die.

Unlike well-located land in a capital city, which might be expected to have a near-infinite economic life, a company might not be around a decade or two from now.

This can present a quandary for investors.

What if you’ve missed the growth phase and have bought into a company that’s now slowly dying?

Lifetime returns

History suggests nearly 2 out of every 5 stocks might prove to be a loser, while 1 in every 5 stocks could see you lose dramatically.

Given we know that becoming wealthy over time is about not losing money – to compound your net worth – this presents investors with a real problem.

Partly due to the tail risks, it’s surprisingly tough to pick a portfolio of stocks which consistently outperforms the averages, year in and year out.

The rise of indexing

The good news is that it’s now easily possible to invest in low-cost index funds which will generate roughly the same return as the benchmark index.

Some companies in the index will inevitably fall upon hard times, but these will drop out of the benchmark index to be replaced by others, and your investment lives on unharmed.

The index returns may be lower than for any given individual company, but so too is the risk.

The risk hierarchy in practice

These days investment products come in all shapes and sizes, each with their own level of risk.

For example, a diversified global ETF probably sits towards the lowest end of the risk spectrum, followed by country ETFs, then sectors.

As we’ve already seen individual companies typically carry a greater risk of permanent loss.

Note that it’s still entirely possible to apply our 8 timeless principles to invest in individual companies.

But to do so safely, it’s typically less risky to look at large, well established, systemic companies, with modest gearing and a decent track record of profitability.

Of course, investors can and do still lose money investing in ETFs and index funds, which is why we suggest that you look for value, to buy low and sell high.

And although ETFs are usually considered to be diversified products, you should still spread your risk across a range of investments.

Since even a cheap index can get cheaper, staging your entry to an investment is a sensible third way to diversify and reduce risk (a fourth way is to hold some cash as a buffer and for its optionality).

Remember, becoming wealthy is about not losing money, so think of your strategy as a series of bets with that core principle in mind.

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Published by petewargent

CEO Next Level Wealth, & AllenWargent Property Buyers, with offices in Sydney, Brisbane, & London. Leading Australian market analyst, & 6-time published finance author. For more see: petewargent.com petewargent.blogspot.com Qualifications including: B.A. (Hons.) Industrial History, Chartered Accountant (FCA), Diploma Financial Services (Financial Planning), Chartered Secretary, Advanced Diploma Applied Corporate Governance.

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