An idiots guide to investing on the stockmarket - part 4

 Risk

Okay, before I start, I'm going to tip "Northgate" and "Tullow Oil" as my two stocks to watch for the next few weeks. They are going places, especially Northgate. Its currently 23.8p but used to be £2.60...and now its recovering, and I've heard some positive inside info from people in the know.



Now onto the idiots guide to investing. As promised, I shall explain that wonderfully wispy concept of diversification of risk and why investing is a rich man's game. 

Basically its like this: You are a human and will always be fallible. Stocks can go up or down. You think a stock will go up...it might do, or it might go down. Every time we make an investment, we are increasing our exposure to the market, and thus also our risk of loss.

All this means that we need to take steps to reduce the risk of being wrong. How? Well there are a number of ways, but the simplest is "diversification of the portfolio". Basically this means buy a whole load of stock in various different sectors of the market, rather than just a single stock.



Okay lets understand that.

The stock-market is made up of many different smaller sectors where similar companies are listed, for example the Pharmaceutical sector lists companies likes GlaxoSmithKline, Astrazeneca and Shire, while the Oil lists BP, Heritage Oil, and Tullow Oil. 

Also, the entire market is cyclical in its ups-and-downs, as are the sectors...generally. But crucially, the ups-and-downs of the various sectors come at different times...So it makes sense to not buy, say, all three of Glaxo, Astra, and Shire, but rather only one of them, and one of the Oil companies. As at any one point you won't be exposed to the risk of the Pharmaceuticals or Oil sectors being wiped out.


In other words, chances are if one sector of the market is hit, another is doing well - so if you spread your bets across the board, you will strike lucky somewhere and perhaps lose somewhere too - but the net result is that you're still breaking even at least.

An example of this is the direct link between airline stocks and oil stocks. Airplane companies' main expenditure is on fuel - oil. So when oil prices rise, their expenditure increases and their stock prices fall. So in other words, when oil stocks rise, airplane stocks fall. So either you can buy one or the other and do REALLY well at one point and then REALLY bad at another, or you can do the sensible thing and buy both stocks, and do your buying and selling in the grey areas between the two peaks, meaning you take advantage of both extremes, but with less extreme profits, but also don't lose out in an extreme way.
  
The principle also implies that we shouldn't invest in only one company, as then we are leaving ourselves open to the vagaries of the market, but rather we should invest in at least 5+. We also shouldn't invest in one kind of stock (e.g. just miners) and also we shouldn't invest in just one area (e.g. just the British stock market) as well as diversifying in the risks of the stock we hold (e.g. buy some high risk stock and other more solid ones). And also, we should diversify in the types of investments we make - so buy things like foreign currencies, gold, silver, and bonds etc. (though I would recommend against buying bonds and other financial instruments which involve interest - as interest is morally unacceptable with the rich getting richer and the poor getting poorer, and Islamically it is forbidden.)
 
So to conclude diversify in:
1. numbers of stocks
2. sectors
3. geography
4. volatility of stocks (high risk/low risk)
5. kinds of financial instruments

My portfolio is currently diversified in the following way:

 


The results of that diversification check are fairly amusing actually, as I go on and on about how risky my stocks are...by in reality my actions show how risk-averse my investments are. Pharmas are a low risk sector, industrial transportation is a medium/high risk, oil and gas is a medium risk, and mining is high risk. But I'm adding another mining stock today...so I increase my exposure to volatility and lean my overall risk exposure more towards "high" again.



All this diversification theory (of which I've mentioned only a really basic version) leads onto the next-level crazy, wacky, shadowy world of hedging, and what hedge funds get up to. Next blog I'll be focusing on this rather tasty subject, after which we'll move onto the more placid and rarefied fields of share-price determinants.


But up till now, this is what the "idiots guide to investing" looks like:
1. basic introduction
2. choosing a stock
3. the weapons to understanding the market and some general advice
4. risk control (this post)

And finally, the diversification of risk is even mentioned in Shakespeare's "Merchant of Venice"!

My ventures are not in one bottom trusted,

Nor to one place; nor is my whole estate

Upon the fortune of this present year:

Therefore, my merchandise makes me not sad.

Lets hope our investing doesn't make us sad either!
The Merchant of Venice [DVD] [2004]

 

The Goldsmith opens Pandoras box

Many years ago, gold used to be the medium for exchange - money in other words. Now goldsmiths had excellent storage facilities, safe from most things, etc. So people would leave their gold at the goldsmiths and get a receipt in return. Now what happened was people started trading these receipts for other things, basically using these receipts as money. So the goldsmith gradually worked out that maybe he should start charging people a basic rate for usage of the facilities which he duly did.

Now the goldsmith got greedy. He realised that the receipt holders very rarely cashed in their receipts and retrieved their gold...so he decided to use this idle wealth for his own purposes: He started lending it out on interest. So now he was making a load of extra cash, none of the holders were any the wiser and the goldsmith bought himself a flashy new horse and cart...made out of pure gold (just the cart).

Now the goldsmith got even more adventurous (eyeing the platinum cart now), he decided that as the receipts were now accepted as money, why couldn't he just write receipts for gold he didn't have and lend that out on interest too. This resulted in a whole load of cash and the aforementioned platinum cart and the goldsmith was enjoying life. All the cash was flowing to him, he could just as easily destroy money which, when returned, would still be worth nothing, and he would basically rip it up and write a new one to dupe people with or just keep using that one. of course the interest was given to him in very much real money, so he was getting all of the "real" money which was actually worth something.

Now the people who had their money in the bank got suspicious and made what is known as a "run on the bank". They basically asked for their gold back...which the goldsmith had loaned out...thus the goldsmith went bankrupt. Life wasn't so rosy any longer.

Nowadays this so blatantly unfair system is practised legally by all the banks in the world (apart from some Islamic Banks), and even "runs" on the bank wont make a difference, because the Central Bank will just lend the bank money and get them out of their spot of bother. money is not backed by anything and is truly "worthless", hence the rising inflation rates we see.

There are a few incy wincy restrictions such as the reserve the banks have to have in comparison to the money they create and loan out on interest...such as it was 10% in the UK but is essentially down to less than 1% now. so for (using the 10% fractional reserve), £10 in the bank, £90 could be loaned out on interest.

This coupled with the scary fact that banks are the source of 95%+ of the money in circulation today, leads us to understand that the interest to be payable to the bank is only payable if the bank creates new interest fueled loans to pour into the economy, and to pay them we will need even more bank money with interest on top of that loan, and to pay that....

This vicious cycle will go on and on. Inflation, economy collapses and the boom and bust cycle can all be traced back to the abolition of the gold standard (not backing the paper money with gold), and by the adoption of fractional reserve banking.

We need to start to realise the crippling effects of interest in the society such as its widening of the rich-poor divide. And we should campaign for breaking of the yolk that the interest earning bankers have placed upon us, and look to establish an interest-free economy.

(My views find their origin in common sense and Islam, which forbids interest)