Two sides of the same coin

Whenever the subject of investing or investments is brought up, the immediate thought that would come to mind for most people is risk. This is quite appropriate and understandable as investing and risk are two sides of the same coin.

However, the problem is that most of us fail to truly understand what the real risks are in investing. In this post, I want to argue that the biggest risk in any investment is in fact the investor her/himself.

 

Let’s talk about Risk

In any investment, risk can rear its ugly head in many different forms:

  • The investment thesis could be flawed, e.g. the growth projections overestimated;
  • Market sentiment could be negative, leading to prolonged depressed prices, severely testing your conviction;
  • External events could create a shock that could lead to a devaluation of the investment, e.g. war or unanticipated policy changes;
  • Mismanagement – i.e. management could make mistakes resulting in the loss of value, e.g. poor controls resulting in fraud; or bad publicity resulting in a destruction of a brand and ultimately loss of revenue;
  • Disruption – the business could be disrupted by new upstarts using improvements in technology for example.

 

These are merely examples of the kinds of risks in any investment. It is not a comprehensive list. There are many textbooks written on risk. These risks are typically managed by the Investment Manager. They are typically trained to understand risk and how to mitigate these risks. But inevitably, some of these risks may be realised causing temporary or permanent losses. Good returns in other parts of the portfolio may or may not offset some of these losses.

However, there is a risk that is not sufficiently thought through and written about. And that is YOU!

 

YOU are the ‘biggest’ risk

As an investor you are in the driving seat of making decisions on what to invest in, who to consult or invest with, when to invest, how much to invest, when to liquidate an investment, etc. These are all big decisions that you need to make so that you can establish your financial security and grow your wealth. But how often do you spend time to think through these issues and establish strategies and plans that allow you to improve your decision making and reduce this risk? How do you mitigate the risks of your own poor decisions (or no decisions)? How do you mitigate against taking decisions based on emotions rather than a well thought out strategy or plan?

When an investment goes wrong, it’s easy to blame the markets or the fund manager or your investment advisor for the poor performance. But how often have you considered that perhaps you are as culpable or maybe even more culpable for the poor performance of your investments?

Let’s paint a few scenarios and I want you to seriously ask yourself, whether you are guilty of any of these:

  • Inertia – Are you guilty of non-action? How often have you delayed in taking action on an investment decision? With regulations like FICA, the account opening process is quite tedious. How often does this stop you or delay you in getting your paperwork done to start a new investment? If you are serious about your financial security and building wealth for you and your family, then perhaps you would consider what this inertia has cost you. You may not only be missing opportunities in the market as a result of this inaction, but you are also losing time, which is by far the greatest contributor to building wealth.

 

  • Waiting for the Bell to ring? I wrote about this in a previous post. People often ask me whether there will be a market crash or not. And my answer is always the same: yes there will be one, but I don’t know when it will happen. The idea of waiting for the market to crash so that you can buy assets cheaply is excellent in theory but very hard (and probably impossible) to actually implement successfully. During a market crash or a bear-market, the market sentiment is very negative. The mainstream media will be full of horror stories about how much was wiped off the stock market. It will also profile high net worth individuals who have lost a substantial part of their wealth. Market commentators will be talking gloom and doom. No-one will be able to give a clear view of when the carnage will stop. But you have been waiting for this, and needless to say most of you will not go on a buying spree during this time. When sentiment is low, it is very difficult for most of us to actually take a contrarian view and begin buying.

 

  • Not Understanding your Risk Tolerance – If you don’t understand your Risk Tolerance and how you will behave in different market conditions, this may also be a big risk for you as an investor. If you do not have the patience or stomach to wait through a bear market, then you may in fact be selling at a very wrong time. Bear markets can last for any number of periods, but often can last a few years. If you have negative returns in your portfolio for two years say, then you may be inclined to sell your investments. This may be one of the worst times to be selling and in fact may be a very good time to be investing a little more aggressively. But, in this case your risk tolerance or patience may be low – leading you to make a decision to either cash up so that you avoid more losses or possibly invest somewhere else where the returns were much better in the last few years. Again, there is a good chance that you are making the wrong decision. You would be inclined to blame the investment manager for not performing over the last few years. To be fair, there will be times when you do need to cut your losses and move on. The point however, is that you need to be clear (and honest enough) as to why you are making the decision that you are. It is important that you understand the Investment Manager’s investment style and it must also be aligned with your own risk tolerance.

 

  • Driven by Sentiment. In this scenario – you invest when you look at past performance – it’s been great over the last few years and good returns have been made, so you begin investing. Or, you invest in the best performing fund over the past few years. Conversely, you sell because the last few years’ performance has been bad. The problem is that whilst equity markets go up in the long-term, the trend is not a straight line. Look at the graph below to see the annual returns on the Johannesburg Stock exchange (All Share Index) since 1996.

 

annual return

 

You can observe that returns range from -25.72% to +66.62%, an incredibly wide range. One can observe periods of low returns (e.g. 1996 to 1998) or extended periods of very high returns (2004 to 2007).  However, R100 invested at the beginning of 1996 would be worth R905 at the end of 2016 plus any dividends paid out. If you stopped investing in 1997/1998, you would likely have missed the big run in 1999. Or, if you started investing in 2006/2007, you would have had a big loss in 2008. So, you should be cautious of being taken in by the sentiment in the market.

 

  • Not Understanding performance. Many investors do not understand performance calculations. A common mistake monthly investors make is that they look at the value of their portfolio say after 5 years of investing, they assume that the return on the total amount they invested should be for the whole 5 year period. The correct way to look at it is that only the first payment is invested for the full 5 years, the second would be for 4 years and 11 months, the third for 4 years 10 months, etc. Needless to say, they get disappointed with their returns because they have incorrectly calculated performance. Sometimes this disappointment is justified because the fund has actually underperformed. But, it is important to correctly calculate performance so that you can make the right comparisons and the right decisions. Another common mistake in calculating performance is not including costs. This is typical in property investments, the investor takes the gross rental received and divides by the capital invested to calculate a return. However, some or all costs are excluded like levies, municipal taxes, maintenance, etc. This gives a false view of performance.

What can you do to mitigate against yourself?

Understand your Risk Profile and Investing Temperament

Firstly, it is important to understand your own risk profile and temperament. If you would not be able to live through big downturns in the market, then it is important that you choose a fund that would be less volatile and provide more stable returns. In this case, you should accept that you will most likely have lower returns over a long period. If you do select a higher risk fund or investment and you make decisions based on sentiment, it is again likely that you will be entering the market when the last few years provided good returns (which you missed) and exiting the investment when the last few years’ returns were low, locking in your losses. Ensure that you understand the investment manager’s strategy and style and that you are comfortable with it so that you can stay invested over a long period and get the benefit of time in the market.

Develop a Strategy and Stick to it

I have also previously written about developing an Investment Strategy. If you develop a strategy and you stick to it, you give yourself a better chance of reducing the emotional decisions. A good strategy to avoid trying to time the market, is a regular (say monthly) investment. In this way, you set up a debit order and you invest in one or a number of investments on a monthly basis. This is called rand cost averaging. It takes away the decisions on when to invest. Most importantly, it reduces the risk of emotional decisions.

 

Just Do IT.

Take action. Open up the account, sign the debit order increase, list your assets and liabilities (#MyFamilyBalanceSheet), set a goal to achieving your retirement savings and actively work to achieve that. In other words, don’t let inertia set in. If you don’t take action, you will forever regret lost opportunities.

 

LEARN

Those of you who have been reading my posts, will know what I’m going to recommend now: LEARN! It is important to develop your investment knowledge. Whether it is trying to understand the mechanics of the market, how businesses make their money, understanding risk, understanding your own balance sheet and risk profile, your investment philosophy or simply calculating the actual performance in your investments. Investing is an ongoing learning journey and it is very difficult to build financial security and wealth without investing. You owe it to yourself to learn about investing because you deserve it.