Risk: the ugly twin sister of reward
16 January, 2015
Risk is the ugly twin sister of reward when it comes to investing.
All investments carry some risk and it is a fact of life if you want to reap the rewards of investing. Usually it is a case of the greater the risk, the greater the opportunity. This seems fair — the daring deserve a chance at a bigger prize.
For some people, the very thought of risk makes them uncomfortable so they avoid investing in anything other than the safest options. But there is risk associated with that too — not achieving your financial objectives.
Investing in perceived 'riskless assets' may let you sleep well at night but you risk not having choices available later in life because you can't afford them.
Risk cannot be avoided when investing but there are ways it can be managed. At its simplest, risk can be managed through diversification. This means spreading eggs among a number of different baskets so that one single egg (or investment) won't have too big an impact on overall returns.
Knowing yourself as an investor also helps when it comes to managing risk. We all have an investment philosophy, even if we don't know it. It is an attitude so ingrained and instinctive that if we try to do something contrary to it, we are not comfortable. Financial success begins with knowing yourself well enough to determine your risk tolerance; nowadays there are all sorts of tools and tests to help investors 'know thyself'.
If you are fundamentally not a risk-taker but you chase shares because you've been told that's where the big gains are, you'll hate the share market's gyrations, not enjoy what you're doing and probably not do it very well. Similarly, if you are a risk-taker and you end up with a portfolio full of cash and bonds, you will probably not enjoy the experience and will feel unfulfilled.
Risk can also be managed through research and experience. An example from everyday life is that most people who have never experienced a bungy jump regard it as scary and high risk. But seasoned bungy jumpers feel more comfortable with each jump because experience lets them understand the risks and take necessary precautions to minimise them. Every jump still carries risk but experience makes it that much easier to cope with.
The same applies to investing. I remember early in my career when I first began researching companies and recommending which of them was a Buy, Sell or Hold. Talk about sweaty palms every time one of my recommended stocks fell in price or announced some news…
I soon learned that, if I had researched them well and understood key factors driving their profitability, I could sleep at night without having to worry about all the extraneous factors.
It helps if the companies we invest in are good at managing risk themselves. That way, we get sort of a double whammy of risk management. I remember years ago there was a perception that, if a New Zealand company expanded its business internationally, it became riskier because of the uncertainty of operating in a different country with different rules and customs. It didn't help that a string of companies had ventured into the Australian market and failed, or at least stumbled.
Two of my portfolio companies, Michael Hill and Mainfreight, who had been very successful in New Zealand, decided to build their operations in Australia. Eek, additional risk!
However both management teams thoroughly researched the market, starting small (Michael Hill opened only two stores in Australia), and manned the operations with experienced staff from New Zealand. Before long, Michael Hill was earning more from its international operations than its New Zealand business and the company has never looked back.
As for Mainfreight, their expansion into Australia became the first stepping stone in the company's successful journey to a truly global company. There are few parts of the world Mainfreight is not yet operational in; the company's goal of earning 85 per cent of revenue from outside New Zealand by 2017 looks achievable.
Some risks, managed carefully, are well worth taking.