Risk and Return

The local rugby team, the Hurricanes suffered their first loss on the weekend after seven straight wins. What followed from players and coach alike was the risk and reward line. Something which we investment professionals are prone to fall back on. ‘There is no such thing as a risk less investment’ but is it a genuine explanation and when should it be announced as a methodology or strategy – before or after the event and how do we measure risk. It’s easy to measure reward or return but not so simple to measure risk.

In a rugby context the defence strategy has developed over the years to become in modern times, an offence based on defence. The crusaders having been rewarded over the last decade for this strategy and up until the last few years had the players (predominantly backs – to capitalise on their oppositions mistakes). The arrival of John Plumtree has hardened the Hurricanes to a more Springbok like approach to forward play (he came back to Wellington after coaching in South Africa at top level) and more specifically – a strong defence. So rugby teams especially at Super 15 level have sought greater rewards through less risk. This approach is fine until you meet a team (like the All Blacks) who minimise mistakes and build their strategy around a balance of attack and defence. Like the Waratahs.

When it comes to investing, just as in rugby it’s important to understand the strategy, follow that strategy and minimise mistakes. And the only time the strategy (or plan) changes is when the goal changes. In rugby you want to score more points than the opposition and in investing you want to achieve a specific goal or series of goals which make up your expected outcomes and purpose in life. Buying a product doesn’t provide this just as all-out attack does not guarantee victory in rugby.

On Saturday the Hurricanes resorted to high risk tactics when they needn’t have done so. They also displayed a certain naivety in skill and implementation. On reflection they will be disappointed but will live to compete another day.

Just because you can’t see the risk (throwing a no look pass) or measure the risk doesn’t mean there is no risk. A decade ago, many people thought there was very little risk with term investments with finance companies. Now following the events of 2007 and 2008 in which numerous NZ finance companies ‘went bust’ most people think differently. Many of these investors will not live (financially) to compete another day. Ross asset management is another example. The fundamental principles and practices of investment were not followed.

The major issue with most investors is not dissimilar to the Hurricanes in approaching their game against the Australian Waratahs on Saturday. Human behaviour gets in the way of rational decision making. An outcome as opposed to focusing on the strategies and implementation to achieve the outcome. The game plan – this involves both attack and defence.

Most investors struggle to articulate their goals. Short, medium or long term hence they resort solely to outcome (returns) – and buy products which they think will ‘measure up’. Investment expectations can and do differ for different people in different stages of life – but to keep this example simple I’ll use a 55 year old ‘ baby boomer’.

1. Step one (goal)                 an income of $65,000 excluding government super, net of tax at age 65 – to last 30 years, inflation adjusted
2. Step two (the plan) quantitative, qualitative analysis. Strategies of:

Cash Management (budget), Investment portfolio, risk management.

3. Step three (Risk, return, reward) Capability, capacity, reality to achieve target.

Risk assessment questionnaire for both investment and insurance.

4. Step four (asset allocation) what ratios of securities to achieve outcome is necessary.

Equities, Property, Bonds, Cash.

5. Step five (diversification) risk mitigation.

Countries, companies, sectors, types of equities (growth value large small)

6. Step six (review process) Quantitative and Qualitative.

Budget, net worth, performance reports, goals, mortgages, insurances, estate

The role of the adviser is to keep the investor on track and on plan and the only time the plan changes is when the goals change. I’m sure Chris Boyd and John Plumtree were disappointed with the game plan implementation on Saturday – I’m equally sure they won’t deviate much from the plan. They will want the players to review the tactics (throwing no look passes, pushing passes in the 22, chip kicking in the 22 and attempting to score tries one handed)

They (Boyd/Plumtree) will not devise a whole new game plan. A conservative no risk approach. The professional financial adviser has the same job to play – keeping the investor on track and on purpose when external influences provide temptation. With investing there is also risk and reward, it’s just that for most they risk the future for a reward in the now. We saw that approach played out in front of us on Saturday – and the goal (albeit after only 80 minutes) was not achieved.