OPINION: Start with the end in mind when investing

There are many definitions of investment risk. Some reference volatility or investment drawdowns. Others centre on the underperformance of an index or sector average. Often, these are shorter-term measures.

But what does risk really mean to investors? It means not achieving the returns you require over the appropriate time periods. In short, it’s the difference between modest and meaningful investment outcomes.

Consider an investor saving R5 000 a month (adjusted annually for inflation) towards retirement. At a return of inflation +5% – a typical balanced fund mandate – the investment will grow to over R37 million in 35 years (or R4.8 million, if we strip out inflation). If the fund manager underperforms by just 1%, that value drops by 17%. Underperformance of 2% will result in a 31% reduction.

When you are invested in a security and its price falls, it could be concluded that owning it was a mistake. However, it’s important to distinguish between temporary and permanent mistakes. If the price of an undervalued security drops from fair or below fair value to a deeper discount, this can be considered a temporary mistake; one that is likely to reverse. If the price of a security falls due to underlying flaws in the investment case, it is doubtful that losses will be recovered.

How to try to avoid permanent mistakes when choosing securities.

1. Valuation

Irrespective of the quality of a business, the price you pay to invest in it is crucial. If you overpay for a security, the difference between its price and its real worth will become a permanent mistake as it reverts to fair value.

Let’s consider Microsoft as a case study. This company has exceptionally durable economic fundamentals, but for some shareholders it’s been a horrific investment. If you got lured in to the tech hype of the late 1990s, you would have paid a price-earnings ratio of 70 times to invest in it – a bad price for a good company. The subsequent drop in the share price took 16 years to recover.

2. Moat

If the profits you’re using to determine the value of a business are unsustainable, you will get its valuation wrong. Put differently, you cannot blindly extrapolate past profitability into the future without assessing changes in the competitive landscape. Past examples of companies where investors could quite easily have got the sustainability of profits completely wrong include Kodak, Sony, RIM (BlackBerry) and Netscape. While all were at one point highly profitable leaders in their fields, they were unable to withstand the onslaught of competition and changes in technology.

3. Debt

The long-term survival of a company depends on the strength of its balance sheet in its darkest hour. If a company goes bankrupt (or raises fresh capital at a very depressed share price), it results in permanent value destruction for shareholders.

4. Governance

An assessment of management is key: if you can’t trust the numbers, you can’t trust your valuation. Examples in recent years include AIG, Lehman Brothers, Olympus and Steinhoff – all large, trusted names that destroyed value for shareholders.

Portfolio construction

There are two grave mistakes when constructing portfolios, which are at the extreme ends of the risk appetite spectrum. The first is regularly swinging for the fences: building highly correlated portfolios that either shoot the lights out or result in tremendous disappointment for clients. This often involves taking a certain view of the world and tailoring portfolios accordingly. But the odds of accurately predicting both the future and its market impact on a sustained basis are low.

The second mistake is calling in sick because you’re too afraid of getting three strikes. This results in building overly cautious portfolios, with insufficient exposure to equities or bonds to have a chance of beating inflation by the required margin. In both cases, clients could be bitterly disappointed – 35 years too late.

This article provided by NewsEdge.