Questioning Investment Industry Assumptions


It’s taken for granted in the investment world that to increase your gains in the market you need to take on more risk. After all, a big lumbering blue-chip company is unlikely to double in price over the course of the year, whereas a tiny start-up could see its share price double in a matter of months.

That part is true enough. But the perception of risk and reward is so common, in fact, that few people stop to fully question this assumption. That’s a mistake. You should never take anything at face value.

Always examine both sides of the proverbial coin before the toss.

Question everything

George Bush senior touched on this subject when he spoke at my University of Michigan graduation ceremony in 1991. He addressed us from a raised podium. No less than 30 secret service snipers were propped among the football stadium’s floodlights. We’d all passed through numerous metal detectors. But perhaps they were worried a radical student had sharpened his mortarboard, planning to toss it like some ninja throwing star.

Bush appeared oblivious to that possible threat. He told the youthful crowd of soon-to-be professionals, ‘Question everything. Just because something is legal, does not make it all right.’

I’m no big fan of the former president, but those words did stick with me. As did the flipside of that coin. My mate summed that up nicely. She leaned forward and whispered, ‘And just because something is illegal doesn’t mean it’s not all right either.’

Fair enough. Question everything.

Licensed to advise

Fast forward 24 years and I’ve recently completed my ‘RG-146 Compliance Solution 923 Securities’ course. Have you heard of that? I hadn’t. But an RG-146 course is a necessary certification if you want to provide general financial advice in Australia.

I must admit, I was disappointed when Tony Abbot didn’t offer a commencement speech following my ‘graduation’. I had to make do with a pat on the back from Port Phillip’s HR Director. Thanks Suz!

Anyhow, the course covers equity and debt securities in depth. It offers a good overview for financial planners, really. Though with my previous experience, it was mostly a process of jumping through the hoops to gain the needed local certification.

I found the sections on risk quite interesting. Around 15% of the entire course falls under the heading ‘Assessing financial risk for client portfolios’.

Here is a quote from the textbook (emphasis mine):

There is a direct relationship between risk and return — the higher the risk associated with a certain investment, the higher the expected return should be (and vice versa). This is because investors should be rewarded for taking on risk.

Later in the chapter, the text book offers seven ‘model portfolios’ as examples. These range from 100% income at one extreme (cash and Australian fixed interest) to 100% growth at the other extreme (Australian shares, A-REITs, and international shares).

The textbook then shows how portfolios with greater growth allocations performed better (from 1981 to 2009) than those skewed towards income. The all-growth portfolio returned an annual average of 13.35% compared to 10.11% for the all-income mix.

The authors neglect to mention which stocks were included in the growth portfolios. Or whether the benefit of hindsight aided their decision. They do mention that the all-growth portfolio ‘is also subject to the highest level of volatility, by a large margin… (and) would have produced the highest level of anxiety for a risk averse investor…’

In its worst year, that portfolio lost 37.24%. I don’t know about you, but losing over a third of my wealth in a single year would indeed have produced a very high level of anxiety!

A tiny Bush

Ploughing through the risk sections, I couldn’t help but envision a tiny George Bush standing on my shoulder. (Yes, I watched too much TV in my youth.) ‘Question everything’, the miniature ex-president reminded me sagely.

The truth is that bullish advisors tend to do well in a rising market and poorly in a falling market. While bearish advisors have the opposite results, making good gains when the market falls but generally losing when the market rises.

That’s what you’re told to expect when you invest in the market. And if you accept that at face value, that’s what you’re likely to get. So take some time to examine the other side of the coin — the side most analysts keep face down. If you do that, you’ll get a different picture.

The fact is that taking on more risk does give you the chance to reap larger returns. But it also gives you the chance of making larger losses. In other words, although that promising small-cap startup could see a 100% leap in a matter of weeks, it could also see a 50% fall…or more…just as quickly.

I offered Albert Park Investors Guild members the following example back in July last year. I’ll share it with you now.

Instead of high risk stocks, think of companies like Wal-Mart, Coca-Cola, ExxonMobil, and McDonald’s. You could hardly call these companies speculative start-ups. In 1990, these companies already had a lengthy track record of proven profitability.

Yet if you’d split your investment capital between these four companies in 1990 they would have returned 1,570% by now. That’s almost eight times what your bank would have paid and well above the 300% investors in the ASX 200 made.

The point is that the key to preserving and growing your wealth does not lie in taking on more risk. The key is all about investing in the proper allocation of high quality companies. And that philosophy is one of the cornerstones on which the Guild’s three portfolios are built.

Take the Guild’s Wealth Havens portfolio, for example. This portfolio is designed to be easy and inexpensive for you to invest in. It’s also designed to be a stand-alone portfolio, if you don’t want to go to the time and expense of investing in individual — and sometimes international — stocks. Importantly, it is meant to offer you a low risk means to preserve and grow your wealth.

So how does this low risk investment philosophy stack up? Well, if you’d bought each recommendation at the time they were tipped, and held them in the allocations recommended in the Guild’s Secret Strategy of the Rich report, you’d currently have realised a gain of approximately 13% since August.

If instead you spread your investments across all three portfolios according to our timing and recommended allocations, your gain would be around 17% since August.

So much for the ‘direct relationship between risk and return’.

To find out more, click here.

Bernd Struben
Chairman, Albert Park Investors Guild

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Bernd Struben

Bernd Struben

Bernd Struben is the Managing Editor of Port Phillip Publishing. Bernd has worked on four different continents, and has more than 20 years of professional finance, editorial, and management experience. He holds a degree in economics.

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