How to reduce investment risks

What is investment risk and can it be controlled? Simply, it’s the probability that investors will suffer permanent capital losses.

PSG Asset Management’s Paul Bosman defines it as not achieving the returns you need. For instance, if you’re saving for a pension over 35 years at R5 000 a month and the fund underperforms by 1% a year, that makes a significant difference. If it underperforms by 2%, investors have 30% less retirement capital.

So how do you reduce this risk and enhance returns? Have patience, spend time in the market and diversify your portfolio.

Temporary mistakes are where you’ve invested in a stock which then falls from fair value or below to a deeper discount. These mistakes tend to reverse when markets calm down.

Permanent mistakes occur when one calculates a company’s intrinsic value incorrectly. Just three bad years over a 32-year history could undo the benefit of inflation plus 5% returns.

These permanent mistakes include valuation, debt, moats and governance. Identifying potential lead balls that drag you down takes legwork, says PSG’s Dirk Jooste.

For instance it’s easy to overpay for an asset, which then reverts to its fair value. If you invested in Microsoft during the 1999 dot-com hype you’d have waited 16 years to recoup your initial investment.

“It’s also easy to believe a highly successful company has a competitive advantage. If you’re incorrect, your cash flow projections will be woefully inaccurate. It is important to follow track records, look for evidence of superiority,” says Jooste.

“Are new entrants disrupting? Are there industry players that are not profit sensitive? Are there political or regulatory considerations at play?”

Similarly, if the balance sheet is not strong it will not withstand recessions, forcing investors to face consequence such as a highly dilutive rights issue.

“The likes of AECI, Grindod, Raubex and Anglo American Platinum all faced tough times. But they will survive for the long haul,” Jooste says. “That’s because unlike Lehman Brothers, ToysrUs or New Look, they were not saddled with too much debt.”

In terms of the risks poor governance impose on a company, he says: “If you can’t trust the numbers, you can’t calculate a margin of safety.”

He believes it’s important to have a governance checklist: ensuring shareholder interests are aligned with those of management; being aware of possible conflicts of interest; paying attention to executive remuneration and ensuring transparent reporting.

Two other risks to note are when your investments are too highly correlated and hiding in cash, believing it’s safest.