It can be confusing to understand the financial system. To help, this is a conceptual financial journey, there will be exceptions.
Before we start:
- We pay a premium (extra) for certainty
- Risk – Risk is that we get something other than expected. This is a function of time (how long) and diversification (how spread out our investments are, many eggs in many baskets).
- Volatility – Volatility is how bumpy the ride is. Volatility is the price we pay for outsized returns over the long run.
- Everyone needs to make a profit or they wouldn’t do it.
Sam earns money and saves it in a bank. Sam earns interest, knowing exactly how much interest will be received each month with relative certainty.
The bank paying the interest needs to make money to pay staff, rent, shareholders and so on. So the bank loans money out to Chris to fund a business. The bank charges a higher rate than what it is paying Sam. The bank knows that not everyone or every business will pay this back. This is built into the price.
Chris’s business takes the loan, they need to be able to pay this back and make an additional profit. If they don’t they will go out of business. If enough businesses fail, the bank too will fail. This doesn’t tend to happen.
Jo, on the other hand, wants to maximise return over the long term and invests directly into businesses (equity). Jo gets a higher return, with less certainty (riskier) and a bumpier ride (volatility), some months Jo gets a lot, other months a little. Some businesses fail, enough don’t and Jo gets more than Sam over the long run.
Equities > Loans/Bonds > Cash
Risk and Volatility
Cash < Loans/Bonds < Equities
We can see through this journey, in more cases than not Businesses, by design, will be more profitable than a Savings account over the long run. It is also riskier and more volatile. Diversification across businesses and even asset types reduce this risk and volatility.
We want to invest as efficiently as possible and as it is difficult to know which companies will succeed.
My strategy remains to invest in a diversified passive (not actively picking stocks) index fund, giving me the best risk-adjusted return.