Beginner’s guide to investing part 2: risk, volatility and why invest?

In this second part, to the beginner’s guide to investing, I look at why and how. Why are you investing? How you balance risk and volatility, depends on what you want to achieve.

Article updated: 9 October 2020 12:00pm Author: Michael Baxter

Superficially at least, all investors want to achieve the same thing. They want to maximise the return from their money. But it is when you drill down, you see the most significant differences emerge. Because the answer to the question: ‘why are you investing’ does vary. And it boils down to the difference between risk and volatility.

In part one to the beginner’s guide to investing: I started with all those simple questions, that people sometimes feel awkward about asking. 

In part three III, I look at some tips to investing. Today, armed with some necessary information that you may have gleaned from part one, or which you may already have known, I start with the first question investors should be asking themselves: “Why are you investing?”

And I’ll start with the two extreme answers to the question. You may be investing, because you are retiring, or indeed have retired, you have a lump sum, and you want that lump sum to provide you with an income. The other extreme is that you have a 30-year plan. In 30 years, you either want to retire, or you want to boost your income, or maybe you will want to fund a significant item of capital expenditures, such as the dream house you would never be able to afford from your regular income.

There are multiple places in between those two positions, an indefinite number of permutations and combinations, but those two extremes illustrate my point.

And to understand the importance of the why question, you need to realise that there are two types of stocks: growth and income stocks.

Growth and income stocks

The term ‘growth stocks’ relates to companies that typically operate in a sector with lots of growth potential, but that usually, to realise the potential, companies need to invest heavily. They usually need to take most of their net profits and re-invest them.

Income stocks relates to companies that typically operate in mature industries with limited growth potential. They don’t need to re-invest such a high proportion of profits to fulfil potential, so they pay a big chunk of profits out as dividends.

What those dividends mean in terms of percentage return depends on the share price. But right now, there are some big dividend yields out there, sometimes as high as 10 per cent, which, when you consider how low-interest rates are, represents a most appealing return.

Some companies get a one-off injection of money — maybe they sold an asset or subsidiary or had an outstanding year they don’t think will be repeated. Under such circumstances, instead of paying out a dividend, they might buy back shares. Share buybacks, then, are often like one-off dividend payments.

You do get some companies that sit in both camps. They are growth and income stocks. Apple, for example, has engaged in massive share buybacks while simultaneously enjoying very rapid growth.

Using dividends to fund growth

Some investors, looking at a relatively short time frame, maybe they want to save up to buy a house in eight years, may see high-income companies as a way to achieve this. Let’s say they can save £10,000 a year. And let’s say they invest via an ISA, making any income or capital gains from their investment tax-free. And let’s say they have an eight-year plan to use the money saved as a deposit for a house. If they were to save their money in a bank savings account, the interest rate would be so low that it is almost negligible. But let’s say the investor manages to find a bank account that pays out one per cent interest. Ignoring tax, their £10,000 a year for eight years would be worth £83,000. If instead they had invested in shares paying out ten per yield, their £10,000 a year would have accumulated in value to £114,000.

But there are problems with this strategy; I see two reasons to beware of income stocks.

Two reasons to beware of income stocks

Firstly, not all dividend payments are sustainable. A company may be paying out high dividends relative to its share price, but if that is so, why don’t the markets push the share price up? If a company yield looks too good to be true, maybe that is because it is. If a company is forking out huge dividends and you want to understand whether it is sustainable, consider three factors:

  • The dividend cover — whether the profits cover the dividends
  • The potential for growth or at least the capacity to avoid contracting profits in future years — is the company operating in a declining market, for example
  • The balance sheet — are its assets relative to liabilities and current assets relative to current liabilities sufficient to cover dividends without running up debts?

My second reason to beware of income stocks relates to investing in a period of rapid change. A virus, such as Covid-19, might be the cause of this rapid change. Other possible causes include an underlying force such as climate change, or maybe it is down to rapid technology change, or what they call disruptive technology.

Consider, as an example, the oil industry. Companies like BP or Royal Dutch Shell are usually big dividend payers, and a staple part of any investment portfolio focused on income.

But oil companies are being hit on three fronts: Covid-19 and related lockdowns affecting the oil price, climate change creating a long-term existential threat to the oil industry and disruptive technologies such as renewables, electric vehicles, and plastic alternatives. Oil companies may no longer be reliable income stocks as they used to be.

Growth stocks

Growth stocks typically offer much higher potential returns than income stocks. Given this, why not just invest in growth stocks and fund retirement by selling off some of your shares, each year? If a share price doubled in value every year, and every year you sold half your shares in this company, your portfolio would retain its value. You could invest £10,000 as a one-off, and sell £10,000 of shares after a year and still own shares worth £10,000.

That may seem like magic, it is what people mean by ‘free lunch,’ but is there such a thing as a free lunch?

There are two problems with this approach.

The first relates to the unpredictability of the future; the other relates to volatility.

You have no way of knowing for sure whether a company will carry on growing in the long run. You can, however, mitigate against this risk by investing in lots of companies, diversifying in companies operating in different industries, such that you can feel quite confident that you will see rapid growth in your portfolio, even if some stocks fail. I’ll return to this next week.

The other issue is volatility. Even if you managed to get hold of a newspaper from ten years into the future, there is still risk. Let’s say you knew shares in a particular company would increase significantly in value over those ten years. There would still be a risk in buying that stock if you need to see some return before that ten-year period had ended.

The problem is that even in the case of spectacularly successful companies, from time to time, their share price goes down.

Let me illustrate my point with an extraordinarily successful company: Apple. Shares have increased in price ten-fold since 2010. Yet, if you had bought into Apple in August 2012, and sold a year later, or even 18 months later, you would have made a loss.

Shares go up and down, for growth stocks these fluctuations can be extremely significant. If you have correctly selected a stock that sees rapid growth over time, then in the longer term, your shares should go up nicely. But you could not rely on such a stock to fund your income.

And that is the point about volatility. When you sell a share in a successful company to realise the profits from your investing, timing is everything. You can be unlucky and sell on the dip.

Let’s say you have set yourself a target date to sell. Let’s say that date is ten years from now and you buy growth stocks. That is a risky strategy, because, in ten years, stocks may be going through a down-phase. One of the golden rules of investing in growth stocks is only ever to sell because you think market conditions are right to sell and not because you need the money.

And that is why for income investors, investing primarily in growth stocks is risky. An income investor who relies on selling growth stocks, by definition, sells when they need the money.

Next week I will look at tips for investing, including the three Ds —diversification, diversification and diversification and the three Rs — research, research and research

Read part 3: five tips for investing.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees.

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

A beginner’s guide to investing