Shareholder Ratios — The Hidden Risk of Ignorance

in investing •  last year  (edited)

Not enough people understand the benefits of participating in capital markets - 7 minute read which might have a serious impact on your future wealth

Most people are overly cautious when investing their money in capital markets. They prefer money in savings or checking account, because of a perceived lack of opportunities or that it seems to be the most secure option.

However, this couldn’t be further from the truth and instead is a great way to lose your assets over time due to inflation: Year after year the value of your money decreases on average as central banks target a rate of inflation of around two percent per year which can easily be counteracted by investing in capital markets. Most people don’t take advantage of this, indicating the overall problem -financial illiteracy- as stated by Guiso et al. (2002) or van Rooij et al. (2011).

For a simple comparison, consider the two countries USA and Germany; both have a strong economy and reasonably stable capital markets. In Germany, there is an exceptionally low stock market participation rate, while in the USA lots of people are engaged in the stock market.

In the USA the stock market participation rates increased from a total of 48% in 1988 to 62% in 2008 and decreased to 54% in 2017 (Gallup, 2017). The rate in Germany, as of 2017, is at 15.7% (DAI, 2017).

Many people are still convinced that their savings- or checking accounts are the best way of keeping their money safe. In the USA, 30% of people agree that a savings account is the ideal investment product for them. In Germany, 25% agree. In the USA, 12% find their checking accounts to be the best choice for keeping their money safe. In Germany, 9% of people agree (ProAktie, 2016).

A lack of participation in capital markets in general, aside the various investment channels of retail investors, seem to be outdated and wealth-diminishing. When looking at how people allocate their assets, this problem becomes even more evident. The average US citizen invests 4% of their money in stocks, 4% in mutual funds, and only 2% in ETFs. In Germany, the average person keeps around 3% in stocks, 7% in mutual funds and only 1% in ETFs. It’s no surprise that only 26% of Germans and 43% of Americans are satisfied with their current financial situation (ProAktie, 2016).

So why are such few people considering investing in stocks?

There are several factors that keep people hesitant when it comes to investing in the stock market. First of all, a large portion of the population will only make investment decisions when they are being advised to by their bank. However, since many people lost their trust in bankers in the aftermath of the 2008 financial crisis, traditional investing has become quite cumbersome (World Economic Forum, 2016).

Due to increasing regulation and rising associated costs, banks have been having a hard time providing attractive offers to their clients. This mainly affects people with small to medium amounts of investment capital, as for banks those volumes are just not worth the effort in offering individualized service and unbiased investment consulting (DAI, 2017).

Another factor is the human unpredictability most retail investors bring with them. Many people who have not done their research will buy high and sell low due to psychological pressure and the fear of missing out. Since people are usually more impacted by losses than by gains, this leads to a negative perception of capital markets leading them to avoid equity investments entirely.

All in all, people have lost faith in the stock market as a result of repeated losses and a lack of adequate consultation.

Why is investing important regardless of these trust issues?

The majority of retail investors lose critical amounts of their savings every year as a result of inflation and opportunity costs and making this clear is imperative. Many people are not even aware of inflation, or it’s effect on the value of cash holdings. People need to understand that they will lose a significant amount of money slowly over a prolonged period of time, unless they take action. With an average return of 6.5% (after accounting for inflation) over the past 118 years in US Equities alone, everyone should be considering investing their money in capital markets. Over the past 118 years, an investment of 1$ would have grown to 1654$ regardless of financial crises, recessions and world wars (After accounting for inflation). In the same time period, global stock markets also grew overall, on average by between 3%-6% per year (Credit Suisse, 2018).

Long term participation in global equity and bond markets is an investment in the continuous growth in efficiency and the technological progress that has been a part of society. Thus, you will hardly find a broad equity index that has lost in value over a rolling ten-year period, while in the short term, history provided several examples of financial turmoil. When it comes to long term investments, not engaging in capital markets will guarantee the inflationary loss of wealth of about two percent per year without any upside potential. For capital market investments though, the opposite is true: in short term you could potentially lose wealth while for the long term you receive a significant risk premium above the inflation rate as in Boudoukh et al. (1933) or Ibbotson et al. (1976).

It has been shown, that the simplest and most reasonable way for private individuals to invest their money is passive investing. Participating in diversified broad indices is highly advantageous because it’s a way to distance oneself from biased advisors giving stock picking recommendations or selling costly managed vehicles and leads to high average returns due to low cost structures. Research shows passive investing to be much more effective than active investing when looking at investment returns. A study by Burton G. Malkiel et al. (2005) of Princeton University compares active funds and a passive Investment in the S&P 500 with an investment duration of 20 years. The passive investment outperformed the actively managed ones by 2.24% per year.

How can private individuals passively invest their money?

The simplest way is by purchasing an affordable ETF portfolio. The advantage of ETF portfolios is that they are generally very cost efficient, transparent and diversified within a variety of stocks and countries, minimizing risks.

Another advantage of ETFs is the separate custody of client funds in a special purpose vehicle, terminating any issuer risk. If the issuer of the ETF goes bankrupt, the client’s money can not be recovered by the bankruptcy trustee (NASDAQ, 2017).

Another option for customers is the use of so called Robo-Advisors. Robo-Advisors automatically invest your funds as digital asset managers, mostly algorithmic and with the help of low cost ETF portfolios. The advantage here is that computers will always behave rationally and objectively, offering a simple alternative for investors who don’t have time to research their investments thoroughly. This is however usually reflected in the costs.

Conclusion

Since research has shown that on a long term on average no manager is able to predict stock market prices, investors are better off in buying low cost diversified ETF portfolios to grow their money substantially. Ultimately, it’s incredibly important that society starts being educated objectively about the opportunities and risks associated with capital market investments. Those who remain oblivious pay a high price, as shown in this article. Either losing a portion of their assets to inflation or overpriced services every year.

“Obviously you don’t need to be able to predict the stock market to make money with stocks” 

- Peter Lynch


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Sources:

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Dimson, E. & Marsh, P. & Staunton, M. (2018) „Credit Suisse Global Investment Returns Yearbook”. Credit Suisse(https://www.credit-suisse.com/media/assets/corporate/docs/about-us/media/media-release/2018/02/giry-summary-2018.pdf); accessed July 2018.

Fabian, D. (2017) „ETF Risks: Truth Or Fiction?“. NASDAQ (https://www.nasdaq.com/article/etf-risks-truth-or-fiction-cm766841); accessed July 2018.

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Guiso, L., Haliassos, M, Jappelli, T. (2002) „Household Stockholding in Europe: Where Do We Stand and Where Do We Go?”. Economic Policy, Vol. 18, No. 36, pp. 123–170.

Hinrikus, T. (2016)„What will the bank of the future look like?”. World Economic Forum (https://www.weforum.org/agenda/2016/02/what-will-the-bank-of-the-future-look-like); accessed July 2018.

Ibbotson,R., Sinquefield, R. A. (1976) “Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns (1926–1974)” The Journal of Business, Vol. 49, No. 1 , pp. 11–47.

Jeffrey, J. (2017) „U.S. Stock Ownership Down Among All but Older, Higher-Income”.Gallup Survey. (https://news.gallup.com/poll/211052/stock-ownership-down- among-older-higher-income.aspx); accessed July 2018.

Lynch, P. (1989) „One up on Wallstreet”. Simon and Schuster Paperbacks, p. 5.

Malkiel B. G. (2005) „Reflections on the Efficient Market Hypothesis: 30 Years Later”. The Financial Review Vol. 40, No. 1, p. 3.

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Wismer, D. (2014) „Warren Buffett: ‘Investing Advice For You — And My Wife’“. Forbes (https://www.forbes.com/sites/davidwismer/2014/03/02/warren-buffett-investing-advice-for-you-and-my-wife-and-other-quotes-of-the-week/#415e08f96e2c); accessed July 2018.


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