Exposed: Top Managers' Approach To Investment Risk

Exposed: Top Managers’ Approach To Investment Risk
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If you have a ‘self-invested’ pension or you make the decisions about investing your money, you need to read this excellent Strategic Report on investment risk

Valuable Insights You Need To Know About Investment Risk

Scottish Mortgage Investment Trust’s Approach To Investment Risk

Annual Reports can often be as dull as ditchwater, but this one stands out from the crowd.  Contained within the 2015 Annual Report from Scottish Mortgage Investment Trust is a Strategic Report from the fund managers revealing their approach to investment risk.

The managers of the Scottish Mortgage Investment Trust global fund give an excellent insight into their thinking for the next five years, together with an analysis of how they approach investment risk.  As they preside over the top performing global fund, it’s well worth seeing what they have to say.

You can download the Annual Report here.  The Strategic Report is found on page 14.

The Primary Investment Risk

Joint fund manager Tom Slater says: “The primary risk is the potential for permanent loss of capital.  There are many other definitions, but our objective is to generate long-term capital growth for our shareholders.  To achieve this objective, we must assume risk and accept the possibility that this may lead to a reduction rather than growth in the Trust’s capital base.”

They take the view the best way of mitigating investment risk is to assess the prospects for the companies behind the shares in five or ten years’ time, rather than focusing on short term volatility.

To help with their analysis, Slater and his joint fund manager James Anderson produced a table compiled from looking at the rolling five year returns for each stock in the US S&P 500 index between 1984 and 2013, giving around 18,000 investment opportunities.

The table below shows how the returns from owning shares are unevenly distributed across the stock market.

investment risk

The table reveals the best 1 per cent of stocks increased shareholders’ money by 13 times over a five-year period.  The top 5 per cent achieved just over a five-fold return.  And the top 20 per cent achieved a return of just over two and half times.

Most importantly, investing in about 1 in 4 stocks resulted in a loss.

“One Of The Significant Risks Is Failing To Identify Big Winners”

Their view, backed up by the evidence, is that most investments are mediocre.  Some will destroy capital and losses are almost inevitable.  It follows that failing to identify and not holding onto winning stocks are the biggest mistakes.

Slater gives the example of Amazon, the internet retailing giant that’s been a long-standing holding in the Trust.  Its shares have soared 240 per cent in the past five years.

“Not owning or aggressively reducing our holding in Amazon would have significantly lowered the returns we would have generated for shareholders over the past five to ten years.”

He goes on to say: “Whilst it is appropriate to measure the performance of the fund over longer periods of time by comparing it to a proxy for the overall market, we find it unhelpful to consult an index when building the portfolio.  Indeed being very different from the index is an important part of reducing risk.”

As a result, Slater and Anderson are quite comfortable holding over 80 per cent of their investors’ money in just 30 stocks from around the world.  They spend a lot of time looking out to ensure the portfolio is properly diversified even as they seek to maximise their focus on the small number of companies with the best prospects.

Traditionally, fund managers tend to use an approach known as ‘growth at a reasonable price’.  This is designed to ensure they pay a fair price for valuable companies.  Slater and Anderson turn this on its head, stating they look for ‘growth at unreasonable prices’.

They say: “We need to be willing to pay high multiples of immediate earnings because the scale of future potential and returns can be so dramatic. On the stocks that flourish the valuation will have turned out to be very low. On the others we will lose money.”

Whilst they’re clearly taking a contrarian view to most fund managers, their approach to investment risk is not unusual.  It’s the one favoured by Warren Buffett, consistently one of the richest men in the world (his fourth top tip listed).

Minimise Investment Risk With Thorough Due Diligence

Finding good investments and minimising investment risk is always about the amount of due diligence you undertake.  Whatever investments you decide to include within your SIPP or your cash, be it a share, fund, loan, bond, property or anything else, make sure you analyse it thoroughly. 

It won’t guarantee success, but it’s likely to minimise the investment risk of you losing your money.

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