Written in 1750 by Adam Smith, whom many consider to be the father of economics, these wise words speak to our appetite for risk and our human propensity for making emotion-driven behavioural errors. To be a truly successful investor the central challenge is to know ourselves and to understand what would be best for us, not anyone else.
Investing is a trade-off between risk and reward. As J. P. Morgan replied when asked what he thought of the stock market, it fluctuates. Any market is made up of people who behave irrationally, led by emotions of fear and greed. Having the right investment strategy for us as individuals is the only way to ensure success.
What is the point of having more capital than you need if you have the same sleepless nights as someone who has less than they need and does not know where the next meal is coming from? A portfolio-owning business, in the form of marketable securities, provides an investor with two-day liquidity not provided for in a pension fund or by owning your own business, property, or private equity.
If you are unable to commit to investing your capital for the long term (a minimum of seven years) and if you lack the patience and confidence to sit through some sharp declines, then you should hold cash, money market funds, or very short-term notes.
With cash yielding a negative real return, you are guaranteed to see your capital depreciate, but this may be preferable to seeing your capital decline sharply in value, albeit an unrealised loss. Owning cash provides optionality. Fear does not listen to reason. A loss is not realised until making a sale of an asset. If you are nervous that capital invested in the market will be lost, then the sensible alternative is to place your capital in an investment with a capital guarantee. But caveat emptor! This comes at a price and it is important to ask how robust is the guarantee.
Market history shows that owning businesses with growing retained earnings and rising dividends will allow your capital to appreciate over time. If this rings true for you, then consider which of the following options you would choose, if you could: 1) stock prices to rise significantly and stay high for several years, or 2) stock prices to fall significantly and stay low for several years? If you chose option one, then you would be in the company of most investors. However, this is against your interests. Why? Just as we buy cows for their milk and hens for their eggs, buying a common stock means buying participation in a business, yielding the right to receive dividends paid on shares. The lower the price of shares, the more shares you receive for the capital you invested and the greater the sum of future dividends you receive as a percentage of your investment. The business also has retained earnings, increasing the share price over time, and what Albert Einstein described as the miracle of compound interest provides the capital appreciation. We cannot invest without absorbing many small interim losses as markets fluctuate, but we should never risk serious irrevocable permanent losses and not invest with borrowed capital.