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What is the True Risk of Investing?

Jenga

Too often I hear people say that investing in the stock market is not for them as they are risk-averse – they cannot stomach the ups and downs of share prices. What they don’t realise is how risky it is to not be investing.

Consider this: An individual saves $10,000 every year in a savings account at an interest rate of 1%. After 20 years, his account would reflect a nominal (Note: nominal means unadjusted for inflation) amount of $232,391 after interest.

But we all know the corrosive effects that inflation has on the purchasing power of cash. If we take into consideration a 3% inflation rate, the $200,000 he has saved up over 10 years can only purchase $173,872 worth of goods.

The scary thing is, most savings accounts in local banks do not offer interest rates anywhere near 1%. This would corrode the purchasing power of his $200,000 savings even more!

And that’s the real risk of not investing – a permanent impairment of purchasing power.

‘So okay, I get it now,’ you say, ‘but investing is still too risky! The prices are too volatile!’ While indeed true that share prices are volatile in the short term, in the long-run it is the business’ ability to grow its money-making powers above the rate of inflation that determines the risk of investing in its shares.

Financial academics have often portrayed the price volatility of investment instruments as a reflection of their risks (using the risk-analysis tool of beta) and the financial media caught on to that idea as well. However, they might have missed the point. Beta measures the price volatility of an individual company’s shares and not the risk of its business losing its earnings power permanently or going bankrupt, which is what investors should focus on.

Warren Buffett sums up the idea of why volatility is not a good measure of risk in a short quote during Berkshire Hathaway’s 1997 Annual General Meeting:

When I first bought Washington Post shares in 1973 it had gone down almost 50%, from a valuation of the whole company of close to US$170 million down to US$80 million. Because it happened pretty fast, the beta of the stock had actually increased, and a professor would have told you that the company was more risky if you bought it for US$80 million than if you bought it for US$170 million. That’s something I’ve thought about ever since they told me that 25 years ago and I still haven’t figured it out.”

Buffett’s 21% stake in Washington Post is now worth more than US$700m, an increase of almost 40 times his estimated purchase price of US$16.8m. That does give some strong evidence about his view on why volatility and investing-risks should be divorced.

The unfortunate thing is that the important risks (loss of earnings power and chance of bankruptcy) are often unquantifiable, thus making potential investors uneasy. The good news is; investors can study the nature of a company’s business, its past earnings and cash flow situation and its balance sheet to come up with close proxies for the important risks.

Over the long run, the share price of a business with above-average earnings power should reflect its underlying business strength and provide handsome gains for its investors. In the process, the investor’s capital is truly protected from the risk of a permanent impairment in purchasing power.

During the global financial crisis of 2007/2009, shares of Vicom (SGX: V01) fell by almost 30% from $1.90 on July 2008 to $1.36 on Oct 2008. That’s a volatile drop in its share price making it more ‘risky’ in the eyes of academics, but its business was in fact growing. Sales grew by 6% to S$73.7m in 2008, while profits jumped by 17% to S$15.8m. Its underlying business strength was eventually reflected by its share price as it has since moved steadily upwards to $5.08 today.

There are other examples of  how share prices reflect the underlying business strength of a company. SuperGroup’s (SGX: S10) profit has grown more than 240% from 2005’s S$23.3m to last year’s S$79m. Consequently, the instant beverage manufacturer’s share price has appreciated by 620% from $0.45 at the start of 2006 to $3.24 at the end of 2012. How about infrastructure engineering firm Boustead’s (SGX: F9D) roughly 260% share price growth from the start of Jan 2006 to June 2012 that was accompanied by a 120% increase in yearly earnings from March 2006 to March 2012?

The experience of companies like Vicom, SuperGroup and Boustead  are  a good example of why we at the Motley Fool believe that buying and holding shares with good long-term prospects is one of the best ways to build long-term wealth and protect your capital from a permanent impairment of purchasing power.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.