Protect your capital through risk management
RISK management is often underappreciated by investors because it is not always obvious what risks they really face when making investment decisions.
An important risk that many investors face, often unknowingly, is concentration risk. This is where an investor has all his or her investment assets exposed to either a single investment or to a few investments that are similar, and as a result is exposed to the risk of losses so significant that recovery would be unlikely.
Put simply, you have all your eggs in one basket, and your entire fortune depends on the success of this basket.
Business owners are one example of investors who are often faced with a great deal of concentration risk, because they tend to invest most of their surplus funds back into their own business. Although the decision may make sense for a variety of reasons, the concentration risk remains.
Diversification, or spreading one’s investments across different assets, reduces concentration risk but is often not executed correctly.
Take the case of a restaurant owner who believes he is diversifying his portfolio by investing in several different restaurants. Although each may have a different menu, location and target market, they all belong to the same industry and are often in the same city or country. The restaurant owner’s portfolio relies on the city’s or country’s restaurant industry performing well, which itself is driven by specific factors. This is known as “naive diversification”.
Investors who favour direct property investing with the aim of creating a rental-income portfolio often face the same naive diversification by way of investing in a specific rental market, often in one city – for example, investing in residential apartments to serve the university student market in the city in which the investor lives.
It is common for property investors to purchase properties in the city in which they reside, particularly if they manage the properties and rentals themselves. Although this may be convenient for the investor, the rental portfolio relies on the student rental market in that specific city or suburb (if close to a specific university or institution) performing well, which is typically driven by rental supply and demand factors, among others.
In another example, senior employees working for listed companies often enjoy bonuses paid out in vesting company shares. If one’s investment portfolio comprises mostly these shares, through loyalty and accumulating them for many years, this, too, poses a concentration risk.
A further risk is liquidity risk, the risk that the investment won’t have a buyer or seller at the time of the transaction, or the risk that an investment cannot be sold in a timely manner at a fair price.
If the restaurant owner needs to raise cash urgently by selling a restaurant, he may be forced to reduce the selling price to below fair value in order to attract a buyer.
The property owner is in a similar position, and there may be additional and meaningful costs as part of the selling process. The business owner may be restricted or averse to selling a portion of the business in order to raise cash.
The first step in managing these risks and naive diversification is to recognise them in the first place. This may not be an easy task for most, and this is where a qualified and skilled adviser can add a great deal of value.
Under advice, the business owner can put in place a framework on how to split further investments into business versus other investment assets.
The restaurant owner may look to diversify his restaurant exposure to include another country or to diversify outside of the hospitality industry entirely.
The property investor can look at ways to manage the property-related risks and improve diversification.
Most importantly, a qualified adviser will be cognisant of each investor’s lifestyle goals and individual risk tolerances when developing a holistic investment strategy that is underpinned by strong risk management principles.
Abdallah Moosa is a financial planner and actuary at Fiscal Private Client Services, a Cape Town-based wealth management company.