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Money Programme

Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

The programme Supersave Me went through a list of different investment and speculative alternatives, from short-term savings products through shares and property to betting on the horses. It looked at different attitudes to investing at different stages in the ‘life course’, with younger savers more interested in setting money aside for a rainy day or a deposit on a house and older savers keen on having an income in retirement. It showed how most savers want to choose themselves, believing they have an edge in choosing cars, property, share or racehorses. And they were all aware that there is risk involved.

There are a number of simple ways in which you can get the risk return trade-off that suits you. Some people, say close to retirement, don’t want too much risk; others, younger, are looking for capital growth which only comes with risk attached. If you have a nest egg, or are saving monthly, just decide how much you can afford to lose. For example, with a £10,000 nest egg, would you be able to survive if it fell to £5,000? Or can you afford only to have it fall to £8,000, say? The smaller the fall you can afford, the less risk you can take on.

Lady holding a piggy bank
with dollar bills falling from the sky.
[image © copyright Photos.com

The stock market, for example, can, as we have seen, fall 40 to 50% in a single year, although that is a rare occurrence. So, decide up front, how much you can afford to lose. It’s likely that if you are in your fifities, you will have a higher minimum value on your nest egg than a thirty-something with years to go before retirement.

You also have to decide your time horizon. If you are investing for 10 or 20 years, and can afford to hang on to your investments, you shouldn’t worry about short term falls as, at some point in the future, prices will recover. That is true of property too, but the problem with property is that it tends to be a ‘leveraged’ investment. People tend to borrow to invest in property, so that a fall in the value of the property or in rents can mean that the loan is called in and substantial losses incurred. People tend not to borrow to buy shares so investing in shares is less risky than borrowing to invest in buy to let.

But the simplest way to make sure you maximise your expected return for a particular level of risk is to diversify across different kinds of assets. Put simply, don’t put all your eggs in one basket. Put some in cash, some in bonds, some in shares and possibly some in property or another ‘alternative asset class’ such as gold or even classic cars. By so doing, you will be making sure that at least part of your savings doesn’t fall. For example, when the stock markets were crashing in 2008, investments in government bonds were racking up capital gains of 30% or more. And if your pot is not big enough, there are plenty of investment trusts or unit trusts who will diversify on your behalf.

And, finally, if you are investing in the stock market, don’t invest it all at once. Regular saving, so called ‘dollar averaging’ means that you don’t put all your money in at the top of the stock market cycle and also that you do put some money in when shares are cheap. Regular saving avoids the classic small investor’s temptation – to buy at the high in the heat of a stock market boom and to sell when prices have gone down.

Take it further with Open2

• Saving time and pennies
• Is tax avoidance only for the rich?
• Private equity - who's paying for their profits?

Take it further with the Open University

• You and your money: personal finance in context
• Debt and borrowing in its wider context
• Introduction to bookkeeping and accounting

About the author

Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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How much attention should companies pay to their share price?

Share prices of all companies have certainly been volatile in the past couple of years. Indeed, individual shares have risen or fallen as much as 25% in a single day. As well as that, most shares have fallen in value by around a half in the past two years and are back at levels seen five or more years ago.

Executive directors had bonuses in share options, so boosting share price made them personally richer

In the twenty first century, shareholder value became the new corporate mantra. CEOs and directors of companies had as main objective the maximisation of shareholder value and that meant boosting the share price. A couple of simple techniques were developed to do this: share buybacks and takeovers. Borrowing money to carry out share buybacks meant more leverage on the balance sheet which meant greater percentage profits growth in the boom years.

Buying companies using debt also increased leverage and allowed the stripping out of surplus cash as dividends. Since executive directors all had bonuses in the form of share options, the more they could boost the share price, they richer they personally became. Directors certainly paid a lot of attention to the share price as the inexorable rise in the early twenty first century could be used to keep investors happy and provide a measure of bonuses to come.

In the bear market since 2007, share prices have fallen faster than ever before - partly due to the embedded leverage of many companies. The worst to suffer have been property companies, financial services companies, and private equity firms whose investments in companies were themselves highly geared. Indeed, for many firms, the options included in bonus packages are 'under water' and new ones at lower prices have been issued.

But falling share prices have other consequences for management. One problem now for many companies is whether they are going to be forced into liquidation as they breach debt covenants. The share price is a reflection of investors' perception of that probability. The lower it is, the less likely that investors will be willing to refinance the firm. Recently, some rights issues have had to be done at 50% or more discount to the current, low, share price to be successful. And, by law, firms cannot issue shares for less than their nominal values of say £1 per share or 25p per share.

Another problem is the lack of loyalty of today's shareholders. In the old days, retail shareholders and institutional investors could be relied upon to invest for the relatively long term. No more. Today’s investors include hedge funds which are just as willing to sell as to buy shares. Some of the major UK banks have ended up part nationalised after sudden collapses in their share price after short selling by hedge funds. Although some people argued that short selling was not the cause, it was banned for a time in the UK on certain shares and even now has to be disclosed.

A low share price makes firms vulnerable, either to bankruptcy or to takeover. And the last thing a CEO wants is to lose control. Just look what happened to John Thain of Merrill Lynch after the takeover in extremis by Bank of America!

Find out more

Do hedge funds deserve to survive?

Why not explore these issues at a deeper level with The Open University Business School postgraduate courses in Financial strategy or Issues in international finance and investment?

About the author

Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

Subscribe to Janette Rutterford's posts

 

Blogging about

Money Programme

Get the facts behind the big business and finance stories from around the world – and down your street, in The Money Programme.

You might think the obvious way to make money in a recession is to be involved in the production or sale of low cost versions of essential items – such as pizzas, bread or pork sausages. But you can still get clobbered by rising costs – petrol, utilities and, when your staff have to pay higher prices, on rising wages too. A more indirect way is to be in businesses that positively profit from others’ distress – here the obvious ones are firms that specialise in sorting out the financial messes that individuals or companies get into. So, bailiffs and company receivers do well in a downturn.

A more straightforward way, though, is to make money indirectly through the stock market. In the old days, it was quite hard to do. If you held shares and the market went down, you lost money. Now, you can easily take a position which makes money when a share falls in price. You don’t even have to be a stock market professional.

Stock market figures.
[image © copyright Photos.com]

You can use futures or options – so called ‘derivative products’ which are linked to the underlying asset you want to trade. If you think, for example, that the FTSE 100 stock market index is going to go down, you can sell futures contracts on the index. Your brokers will require cash from you, to protect themselves if you are wrong, but essentially, you hope the index will go from say 6000 to 5500 and that what you sold at 6000, you can buy back at 5500, pocketing a profit of 500. The more futures contracts you sell, the bigger your profit.

"whether we are living in good times or bad, we can make money from the stock market"

Sounds too good to be true? The problem is – what happens if you are wrong, the FTSE 100 rises to 6500 and you have to buy back at a higher price than you sold? A lower risk way is to buy a put option. For a small premium, you have the option to sell the FTSE 100 say at 5750 when it is currently trading at 6000. If you are right and the index falls to 5500, you can effectively close out your position for a 250 point gain, less the cost of the put option. This way, if you are wrong, you can simply walk away, worse off only by the put option premium.

Investment professionals use futures and options to bet that prices will fall all the time. George Soros is famous for having made a fortune from selling the pound sterling just before it left the European Exchange rate mechanism. More recently, two traders at Goldman Sachs – Josh Birnbaum and Michael Swenson made money out of the ‘credit crunch’ – they sold products linked to the sub-prime market and bought back when prices had fallen. As a result, Goldman made around $4 bn from this strategy and Josh Birnbaum has set up his own $1bn fund trading sub-prime mortgages.

What can you do when markets have already fallen? The answer is invest in a so-called vulture fund which buys securities which have fallen dramatically in price, in the hope that they will recover. So, whether we are living in good times or bad, we can make money from the stock market. The only problem is getting your timing right!

Weblinks

• Join the discussion
• Competitive advantage
• Watch the trailer
• London Stock Exchange - what we do
• How the FTSE is calculated
• Is the FTSE 100 biased?

Courses

• Financial strategy
• Issues in international finance and investment
• You and your money: personal finance in context

The opinions expressed are those of the author and are not held by the Open University or BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.

About the author

Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

Subscribe to Janette Rutterford's posts