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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:

Align incentives?

Assess knowledge?

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.

Carlos Ghosn

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.