The most important idea in investing

Today I want to kick off with a fundamentally important element of investment… something called the equity risk premium.

Welcome to Risk and Reward, your new email about the most exciting opportunities on the market. In every email I’m going to give you unique, useful, and urgent ideas to grow your wealth.

Today I want to kick off with a fundamentally important element of investment… something called the equity risk premium.

The equity risk premium is a dead simple idea. It just means that stocks have been shown to make investors more money than other types of assets, like bonds and property, in the long run.

This is important because when you get down to it, there are only three important asset types: stocks, bonds and property. You need to understand which ones perform better, and why.

Why do stocks outperform the other types of assets? The reason is that they’re riskier. The equity risk premium says that risk and performance are joined at the hip – the more risk you take, the more money you’re likely to make. Stocks are riskier, so they return more to investors.

That’s all well and good… but it only begs a further question. What’s meant by risk?

“The bigger the zig-zags, the bigger the return”

In the investment world risk has a specific meaning. It’s another word for volatility, or the amount by which an asset moves up and down in value.

For example, imagine a tiny company with 20 employees whose shares are trading on Aim. A little bit of good (or bad) news, like a contract win (or loss), could totally transform the outlook for the company and for the shares. The shares in a tiny company like that are likely to bounce around much more than the shares in a giant like British Gas.

That’s what’s meant by risk: the extent to which the value of the asset goes up and down.

I’ve sketched out the relationship between risk and return on the graph below. Risk is represented by the red zig-zags, and return is shown by the blue trend line.

Basically, the bigger the zig-zags (the bigger the risk), then the steeper the slope of the blue line will tend to be (the bigger the return).

RiskReward1

For ordinary investors, the equity risk premium is a godsend. It means that if you’re up for taking your cash out of the bank and taking on increased risk, the market is willing to pay you handsomely for it.

Exactly how well does it pay? Well, look at the following chart. It shows the difference between leaving your money in bonds (this is the safe option – the equivalent of cash in the bank) and investing in stocks (the blue line) in the UK over the last 110 years. Note that they’ve had to use a log scale in order to squeeze everything onto the same graph!

RiskReward2

The chart speaks for itself. Risk pays!

And this is just the start of it. There’s more good news. The chart does not account for smart stock selection, and it doesn’t account for a couple of other generous market “giveaways” I’ve uncovered.

Tomorrow I’m going to tell you about the most important of those market giveaways. It’s related to what I’ve been talking about today. Think of it as a way to turbocharge the equity risk premium.

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