Four Questions When Investing
The essence of investing is risk management as it defines the risks to accept and the risks to avoid. Inherent in the investment decision is ensuring compensation for any risk taken. To paraphrase the Chinese character for risk: risk must present opportunity; otherwise, it is pure speculation. An institutional investor's core mission is to manage risk from the minutiae of the security to the scope of the investment program to ensure achievement of the strategic intent of the organization. Even when the journey takes a path different than the one expected, achieving the objective is still possible for the risk-focused investor. While success is not guaranteed, focusing on risk keeps the investor in the game.
Managing Risk. All investors are pushed off course sometimes. Astute investors from Benjamin Graham to Warren Buffet extol the virtues of investing with a ‘margin of safety’ and ‘intrinsic value’ to ensure when they miss, they miss small. They ensure that the risks are well managed and then permit the returns to follow from the compounding of capital. An investment philosophy intertwined with this belief removes outcomes that results in strategic drift too far away from the objective while permitting participation in opportunities as they arrive.
Future returns in the financial markets are inherently an uncertain game that depends upon timing. Placing too much confidence on uncertain future performance outcomes puts the investor into a situation where time is an enemy rather than an ally. As all visitors to Las Vegas know, in the long run, only the house wins. Investment decisions start with evaluating investment strategies that provide sustainable cash flows independent of the environment. Returns should be as consistent as the house, not variable like the player. While there is no guarantee of success, an investment philosophy predicated on managing risk helps achieve more persistent investment performance.
Defining Success. Not all questions have answers; however, all answers have questions. Determine where you want to go, and the questions will naturally arrive as you work backward to your starting point. The challenge is developing relevant questions that focus on the people that will achieve the investment objective, particularly the critical stakeholders. Whether investing in an individual company or a managed portfolio, an investor needs to ask all stakeholders how they:
Alter their plan?
Act when executing?
These questions are for all stakeholders and include the organization, the investor, the beneficiaries, the investment committee, investment consultants, and investment managers. Investment decisions involve trade-offs and the critical success factors for understanding the decisions are ensuring alignment, filling knowledge gaps, planning for alternative outcomes, and focusing on execution.
Incentives are not a strategy; they are tactics.
Alignment. Over the last few decades business and economic theory moved away from the rational and omniscient individual towards a more variable and incentive focused actor. The key distinction is that the individual will act with imperfect knowledge and their actions will reflect not only their current state but also the present incentives. This evolution in thought for economic behavior is germane to investment management. Stakeholders acted to exploit the incentives present in their sphere of influence, rather than the strategic objectives of the investment program.
Investment consultants earn fees for passive information, not positive outcomes. Asset managers receive fees for matching irrelevant asset benchmarks, not performance related to the investment program. Investment committees are mandated to manage investments irrespective of the impact on the viability of the wider organization. A fallacy of composition results, since stakeholders focus on their unique incentives that may not align with the overall investment objectives.
Aim to make the whole greater than the sum of the parts. Align all stakeholders with the investment objectives. Align investment consultants and managers by naming them as fiduciaries to the investor. Consider the investment objectives, so they are not in conflict with the operating business goals. Align asset managers with value added regardless of benchmarks and use performance-based incentives. Aligning incentives leads to better outcomes.
Information is not knowledge.
Knowledge. The presence of information does not alone lead to a good decision. The information must be married with the experience to separate the relevant from the trivial. Information can label a hammer; knowledge is understating how a hammer can build a house. Investment fiduciaries do not lack for information: they need the knowledge that comes with experience.
Hallmarks of poor investment performance are a lack of awareness of the risk or, if aware, uncertainty on how to mitigate the risk. The former is usually the result of excess and unfocused information overwhelming the message, while the former is the product of insufficient capabilities to address the problem. Knowledge transforms information into coherent decisions.
Focused on extending the capabilities of the investment team by filling the necessary knowledge gaps. This experience starts at the highest level to ensure that the stakeholders understand the investment impact on the wider organization. Knowledge permeates down to the portfolio construction process where the risk tolerance is aligned with performance targets to create sustainable investment objectives. Diverse investment knowledge provides the ability to access the inherent premiums embedded while understanding the minutiae of the security-level risk. Knowledge understands the trade-offs in investment decisions and accepts only compensated risks.
Failing to plan is planning to fail.
Planning. Technology increasingly provides a multitude of information on all aspects of the organization and investment environment. In a data-driven world, the focus is on the ‘number’ rather than a coherent plan to achieve the 'number.' Switching the focus from reacting to the inundation of instantaneous information to developing a proactive plan that embodies an uncertain future improves performance. As the sage sailor knows, preparing for the storm before it arrives is easier during calm waters.
Investing is increasingly a measurement paradigm. Value-at-risk, volatility, active return, factor exposures became the words du jour without the sober second thought of what the numbers are showing, and more importantly, how they may be useful to developing a plan of action. Measuring equity markets falling by fifty percent or interest rates falling four percent is easy. Few investors had a plan in place for when these events occurred, and more critically, a plan to mitigate these risks in advance.
Focus on developing a coherent plan for the investor to meet their objectives. The program starts at the highest with the investment objective for a given investment horizon and down to the current individual security level. Planning considers all the stakeholders and market events whether they are systemic events similar to a financial crisis, the impact of bankruptcy on the debt portfolio, or investment fraud's impact on an absolute return portfolio. Proper planning will not prevent the storm, but it will ensure that the investor can weather it.
Everything depends on execution; having just a vision is no solution.
Execution. The devil is in the details. As the constant app updates on our mobile phones remind us, perfect execution is difficult. Perfection, however, is not the enemy of the practical. As with all skills, effective implementation is born in experience. Even with the incentives properly aligned, the knowledge and capabilities on board, and a thoughtful plan articulated, execution remains the greatest risk. Small errors in execution can lead to large changes in outcomes; hence, the details matter.
Efficient implementation realizes the potential of a well-developed investment strategy, so that achieved outcomes align closely with expected results. Execution starts at the portfolio level to ensure that unintended risks do not enter the portfolio. At the risk factor level, execution understands what risks to consider and when to accept them. At the investment manager level, implementation delivers on the promise of active investment performance. Execution manages the different levels of risk to ensure the strategic intent remains insight.
As a road map to performance, each level of execution requires identifiable and measurable key performance indicators. If strategic drift occurs, it is easier to make course corrections earlier than later. Identifying the critical success factors: alignment, knowledge, planning, and execution helps minimize the risk of investment underperformance and the resulting strategic drift for the investor. While not a guarantee of success, it does ensure the right people are driving together on a well-articulated route to the destination. Fixing a blown tire or correcting a detour are easy: choosing the wrong destination or people is not a strategy risk worth taking.