Ok, so you decided that you want more from of your money. And now you’re thinking “Why don’t invest them in the stock market?” It may look like a good idea, since stock market can sometimes give significantly bigger returns than a saving account (some funds in the past three years reached a performance of +40% per annum).
But you must be aware that an investment in the stock exchange is a risky investment. But what exactly risk is? In fact, many people seem to misunderstand the concept of risk (there are some friends of mine who told me: “but why the stock market doesn’t go up constantly, instead of all these ‘up’and ‘down’ that make impossible understand anything?).
So, let’s try to understand better. There are two kind of risk that we must keep in mind (and distinct!) when we are talking about the stock markets:
- The risk of a negative performance in the medium-long term, i.e. that after n years the value of our shares is less than initial value. This means that we “bet on the wrong horse” (eg. a fund that invests in a sector which did not develop over time). The risk is usually greater if you buy shares of individual companies. In theory, many analysts condsider likely to expect that the stock market as a whole exceed inflation (thus offering a gain in real terms) in the long-long period. But I think not everybody is interested in a 80-100 years long investment… I usually think in a little more short-term… :)
- The volatility in the short term, that means that one day the shares go up ‘x% and the nex day fall of y%. This is often what frightens more who approaches the stock market for the first time, but in fact this may is not as dramatic as one may think. You have to look at the overall trend in a time scale that fits your investment needs: if you are making a few days investment, to look at daily variation makes sense, but if you are planning a medium-long term investment, you should look at the medium-long term trend instead.
You have to have clear these facts when you consider an equity investment (such as investing in a fund), because otherwise you’ll risk to your fingers burnt, tipically buying (for enthusiasm) at the highest prices and selling at the minimum (for disappointment, or fear), which is the worst thing you can do for your money!
Another question I hear often is “but what those macroeconomic data have to do with the socks that I have?”. Or “why the shares go up or down”. Because offer and demand of stocks change, of course.
But there is a very interesting point of view, that I think helps to understand things better. The “right” value of a share is equal to the net present value of future profits, calculated on a for an indefinite time-period. Of course it’s impossiblo to calculate a share value this way, since that nobody knows with certainty what will gain or lose a company in the future: but we can estimate the factors (that are very many) that have some effect on earnings. By changing the environment, also changes the prospects for future earnings, and consequently the value of the shares changes.
One last remark: remember that the past preformance… is past! If a share ore a fund value is doubled in the last 2 years, this does not assures that the value will do it again in the next two years!