There are two components to every financial deal being; return and risk. Often, the vast majority of people fail to assess both with the same amount of diligence and attention because they tend to focus most of their attention on return. However, research shows that there are two common traits of extremely successful and experienced investors. Firstly, they are absolutely fanatical about risk, asking themselves; “what can go wrong?” and “can I lose any money doing this?” Once they are satisfied that the risk of losing money is remote to almost impossible (they never want to lose money), only then do they turn their attention to the potential upside being, return. Secondly, these investors only invest if they can exploit the risk-return equation. That is, they are looking to achieve very healthy returns for comparatively very little risk – they don’t accept that you need to accept higher risk if you want higher returns.
With that in mind, this article will investigate the specific actions you can undertake to de-risk you own investment strategy.
Work to a plan
I believe everyone needs to have a core investment strategy. A core strategy is the lowest risk strategy to get you from where you are today to retirement (maybe a better description for retirement is “financial freedom”). That is, a person that is 40 years old might like to achieve financial freedom at by 55 to 60 years of age. Therefore, a core strategy is the lowest risk strategy possible, that achieves financial freedom by age 60. Once a core strategy is implemented, if the person has additional surplus cash then perhaps he/she can invest and take higher risk – but only after the core strategy is implemented and protected. If the higher risk investments pay off, maybe they will be able to retire before age 60. But, if they don’t work, at least they can rely on the core strategy.
Successful investing is all about achieving the highest return for the lowest possible risk. So invest in quality assets and then do everything possible to eliminate or mitigate all investment risks. Having a clear picture of your strategy is key to achieve this. Let’s look at steps you can take to de-risk your strategy.
Take these two steps to avoid investing in poor quality assets
Without a doubt, the quality of your assets will determine 80% of your financial outcomes. That is, if you invest in high quality assets, you can expect high quality returns. The reverse is also true. Therefore, to increase the probability of being a successful investor (or put differently, reduce the risk of being unsuccessful), you need to focus your energy on only investing in quality assets. How do you do that?
I believe that are two fundamental actions you need to take:
- You need to have a clear idea of what your investment strategy is and what assets you need to invest in to underpin that strategy. For example, your strategy might be to buy three investment properties over the next 5 years and then once that is completed, to invest any surplus cash flow into the share market. You know that the three properties need to be located in major capital cities, be blue-chip properties, have a good land value component, be scarce assets and have proven historical capital growth of more than 7% p.a. In respect to share market investments, you intend on investing in a lost cost index fund. Having a clear strategy in mind will ensure you don’t get distracted by low quality, higher risk “opportunities” i.e. stick to your strategy.
- When selecting assets, you need to get an honest appraisal from a professional you can trust. For example, when it comes to selecting an investment property, don’t think it’s smart to do it all yourself because there just too much money at stake of you make a mistake. For example, even a difference of just 2% p.a. in a capital growth rate will cost you $185k in lost equity on a $500k property over a 10 year period (and $725k in 20 years!). Why try and do it all yourself and risk ending up with an “average” property when you can engage a professional and get an “awesome” property? There’s just too much money at stake to risk making a less-than-perfect decision. Therefore, when selecting an investment property, get advice from a reputable buyers’ agent. For shares, speak to a financial planner or accountant you trust.
If 80% of your returns will be a direct result of the quality of the assets you invest in then it stands to reason that 80% of your time, energy, money and focus needs to be on ensuring you have the highest possible chance of only investing in the highest quality assets. Tax savings, ownership structure, price, cash flow are all important – just far less important than quality.
Protect your most valuable asset
The most important ingredient for nearly every investment strategy is income. That is, most clients need to be able to generate some surplus income (i.e. after paying for living expenses and commitments) to invest to increase their new worth. If you are not able to generate income, you cannot invest and you will never achieve financial freedom. Therefore, it stands to reason that you should insure your ability to earn an income – I’m talking about income replacement insurance.
The most severe risk from a financial implications perspective is longer term incapacity because of illness or accident. If I break my leg and need to take 3 months off work it probably is not going to hurt (financially) that much. However, if I have a car accident and cannot work for say 7 years, that’s going to put a big dint in my retirement/investment plans. Therefore, my advice is:
- Ensure your income is fully insured (typically the maximum is 75% of your gross income). Ensure your policy is ‘agreed value’ and not indemnity. Ensure the product is high quality (an advisor will be able to assess the quality of a product for you).
- If the cost of income replacement insurance becomes expensive, think about increasing the waiting period. For example, sometimes insurance can be half the cost with a 90 day wait period versus 30 days. The longest wait period is 2 years. The longer the wait period the higher the risk you accept so you need to be careful. But even with a 2 year wait period you are protected against longer-term incapacity. Approximately 40% of income replacement claims last longer than 2 years.
- Insurance isn’t an all or nothing decision. It’s more a case of “how much” rather than opting for no cover at all. Some cover is better than none.
As a professional you have educated and trained yourself for many years and as a result your earning capacity has benefited. How much income do you expect to earn in your lifetime? It’s a big number isn’t it? This is arguably your greatest financial asset and it must be protected.
Warren Buffett says that “risk comes from not knowing what you’re doing”
Professional advice has two ingredients; knowledge and experience. Knowledge comes from training, reading, education and so on. Experience comes only with time. When you seek professional advice you are benefiting from these two components but arguably, the most valuable is experience. They say that most people learn from their own experiences, smart people learn from other people’s experiences and dumb people never learn!
When I meet with a new client I have an opportunity to share my experiences. The fact that I have been advising my clients for over 12 years means I have seen a lot of it before. I probably haven’t seen it all but there are very few scenarios or situations that I haven’t come across. I have the benefit of hind sight too because I have witnessed the outcomes of both good and poor decisions clients have made. You need to do very few things right so long as you don’t do anything wrong so do your best to avoid the mistakes that other investors have made before you. Seek out and learn from experiences.
Don’t buy financial products
People will come and try and sell you financial products. Don’t buy them! You determine your own strategy and implement it without distraction. You are better off to ignore approaches by product sales people and stick to your own plans. The financial services industry loves to sell products and dress them up as advice e.g. come to me and I’ll help you discover if a Self-Managed Super Fund (SMSF) is suitable for you – before you know it, you have a SMSF! Instead, you are better off to pay someone a fee for this advice so long as they don’t have a product to sell you.
Risk first, return later
Low-risk investment strategies might be boring because they won’t make you rich overnight but there’s no denying that they work. An investment strategy’s job is not to excite or entertain you. Its sole job is to make your money work as hard for you as possible whilst taking the lowest risk. As such it would be very wise of you to ask yourself “what can go wrong” more often than you ask “what can go right”. Plan for the worst and hope for the best.
If you need any assistance with developing or de-risking your own investment strategy, please do not hesitate to contact us.