OpinionAug 14 2013

Embracing risk

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This will be my final article for Financial Adviser’s Oracle column, and in the 18 months and near 100,000 words I have written, several themes have crystallised in my mind about investing, which I thought I would devote this final column to. I am not beginning to suggest that anything below will rival Howard Mark’s The Most Important Thing, or any other investing tome either in length or insight, but hopefully some of these will be helpful when thinking about how to invest our clients’ money.

First, think long term. There is a simple mathematical reason why this makes sense – risk, in my view, is defined as average position size multiplied by frequency of differing positions taken. What do I mean by this? Put simply, taking a position in a stock, or a region for an asset allocator, is less risky, all other things being equal, when you take the position and hold it, than when you rapidly trade a position of the same magnitude. The more often you trade, or reverse, positions, the more likely you are to get ‘whipsawed’ – hence less trading equals a lower probability of repeatedly being on the wrong side of a trade. I am definitely not advocating sitting in a losing investment forever, but I am saying that, given the amount of work it takes to think through an investment decision, taking longer-term positions and waiting for them to come right is in general a better investment strategy than short-term (daily or weekly) trading.

Second, do your homework. There is no excuse for not knowing something when an investment does not work out. And this does not mean researching and sitting back once invested; it means focused and ongoing due diligence. When buying a fund, you do not necessarily need to know what your fund manager had for breakfast, but you do need to know them well enough to spot the warning signs before things go wrong. And knowing who, behind the scenes, is adding the most value matters too – sometimes it is the analyst who leaves a company that damages returns as much or more than a portfolio manager. It is also important to monitor changes at the wider corporate level. High-level changes implemented by senior management, for example an acquisition or a change to remuneration policy, can have a negative impact on the performance of individual fund managers.

Third, embrace the new, but with caution. There is nothing wrong with new talent, and many fund managers deliver their best investment performance early in their careers. And related to this, do not be afraid of disruptive changes. I am uncertain that passive investing really has damaged active fund management, it has just weeded out some of the less talented. And without the threat of low-cost passive investing, I am not sure there would have been so much research into the ‘halfway house’ that is smart beta – something every investor should at least consider as a potential strategy. And when thinking about stocks, always begin with the destructive view. The obvious example at the moment is three dimensional printing, and the impact it could have on companies large and small across the world. Sometimes the most disruptive change happens just where you do not expect it. I am not sure when Sir Tim Berners-Lee invented the World Wide Web, many people immediately jumped to the conclusion that it would massively impact the book-selling (and by association publishing) industries – but, thanks to Amazon, it has.

Fourth, begin and end every investment decision with risk. This is not saying that you should be risk-averse as sometimes embracing high-risk ideas is the best way to invest. But it does mean never making an investment decision without having thought through what could go wrong and what the impact of that would be, and also understanding how every investment in a portfolio interrelates. Correlation is a funny thing, and more often than you may think two seemingly unrelated ideas have high correlations – mixing art with science here is the best way to think about constructing your portfolio. But perhaps having thought about it, risk is most important when everything seems to be going wrong. It is far easier to have courage in your convictions, and stick with underperforming holdings, when you really did think through what the worst-case scenario was before making that investment. It is too easy to sell out of something in panic, but you can avoid this behavioural error by thinking about risk from the start.

As John Maynard Keynes said: “Successful investing is anticipating the anticipations of others”.

And that is it – I am out of words. Thanks for reading.

James Bateman is head of multi-manager and multi-asset portfolio management for Fidelity Worldwide Investment