When investing, the vast majority of property investors focus on achieving the highest investment return – like they can somehow influence the return.
It’s absolutely crazy! The return will be what it will be.
My advice is to forget about returns. Instead, focus on investment risk, because that is what you can influence.
Find the investment that has the best risk/return payoff.
Confused by this opening paragraph?
Well, this is probably the most important article I have written in a decade… please read on.
The preference shares pay an income stream of 10% p.a. and are exercisable at a share price of $115. At the time of writing this newsletter, Goldman Sachs’ share price was $157.
I estimate that Buffett has already made a profit of $USD1.8 billion (at one point, he was up nearly $USD3 billion). This is a prime example of considering your downside.
Buffett mitigated this risk of ‘zero capital growth’ by structuring the deal with a 10% income stream – so at least he’d earn an income if nothing else. This is a perfect example of how investors think about the downside (risk) first.
Define investment risk
Investment risk is simply the risk that we do not achieve the financial outcomes we need to meet our financial goals (e.g. funding retirement). This risk can come in many forms:
- Market risk is the risk that you select the wrong (poor quality) asset to invest in.
- Legislative risk can come in the form of changes in laws that adversely affect us.
- Financial risk is the risk of not getting access to funding to invest
Interest rate risk is the risk that interest rates will increase to impede your ability to meet your goals.
- Liquidity risk is the risk that you can’t sell your investment within the required time.
To some extent, we can control or influence many of these risks.
Risk and return make up your total return
Investors are often blinded by return.
Greed is probably the second most powerful motivator behind fear.
This has been proven many times in history, with disasters like Storm Financial, the US sub-prime crisis and the list goes on.
Dangle a double digit return in front of most people and they’ll immediately start calculating the profit in dollar terms. We see this in our business too. We speak to people who mention they are keen to invest in well-located, high growth property, because they believe it’s a low risk strategy.
A few months later, you learn that they have purchased a development project with some friends or bought a franchise that they’re going to ‘build up and sell’ – two different investment propositions with vastly different risks and probably highly inappropriate for their risk profile.
Don’t get me wrong. I’m not a super conservative investor (in fact, quite the contrary – my wife will attest to that).
However, there’s a time and place for these higher risk investments. That time and place is once you have implemented a ‘core’ investment strategy that will get your from A to B. Once you have accumulated a reasonable asset base. When your financial situation is strong enough to withstand the possibility of nil or negative returns.
Back to my original point… that is, most people getting blinded by return. The correct way to consider an investment opportunity is to first consider the return. Next, you need to assess the risk associated with the investment – is it low, medium or high?
Finally, you need to decide if there is anything you can do to mitigate or eliminate some of the risks, to bring the residual risk down to an acceptable level. However, many people forget the last two steps. Instead, they look at the gross return and get excited. Interestingly, seasoned and successful investors tend to reverse the approach.
I recall reading Richard Branson saying that when looking at an investment opportunity, he first considered his ‘down side’.
The first thing Mr Branson thinks about is his risk. Interesting!
Perhaps I can demonstrate how risk affects return in a simple mathematical example. Consider two investment opportunities:
1. Investing in blue-chip, high growth, well-located property with the aim of achieving a long term capital growth rate of 8%.
If you engage the services of a professional investment property advisor to buy the best one bedroom apartment they can find, I’m very confident that you’ll have a 90% (or better) chance of receiving at least an 8% growth rate (remember investment grade property tends to perform at around 10%).
2. Undertaking a property development and aiming for a 20% net profit from the project.
Property development represents a higher risk investment. Many things can go wrong such as cost overruns, takes longer to build, problems with builders, not being able to sell the completed property, or selling for less than expected, higher interest rates and the list goes on.
Only a few things need to go wrong to eat into your profit margin and pull it under 20%. Therefore, let’s assume that there’s an 80% risk of not achieving 20%.
We can represent the net investment return by calculating the risk weighted return which is simply the return multiplied by the probability of achieving the target return.
As you can see from the above calculation, the risk weighted return from the development is less than the lower risk investment.
In fact, we could put our cash in a high yielding account and get more than 4% in interest (and this would almost be considered zero risk).
The example might be a bit extreme, but the point I’m trying to make is that many investors do not correctly identify and measure risk in their investing decisions.
This is particularly the case with property investors. I think the reason for this is that property is deceptively simple to understand. That is, people can read some books, do a couple of courses and attend a few auctions and all of a sudden they think they have worked it out and ‘know a bit about property’.
People don’t act the same way when it comes to share market investments. The inherent risk in various investment property opportunities can vary dramatically. Development’s a good example. Many people have made a lot of money from development. Far more people have made very little money. It’s impossible to obtain a high return without taking on a high risk.
However, people forget to factor in “risk” into their decisions.
They get greedy or overly optimistic. We can learn from Warren Buffett.
Here is a great example.
Last weekend, a property in the Melbourne suburb of Bentleigh sold for $1,062,000. Prior to last weekend, the most recent sale of this property was in 1995 when it sold for $250,000. No major improvements have been made since 1995.
The property has therefore quadrupled in 15 years, which equates to a compound annual growth rate of just over 10%.
Whilst Bentleigh is a reasonable quality suburb from an investment perspective, it’s not necessarily one of Melbourne’s blue-chip suburbs. It’s still a pretty good return – right? Imagine if you bought in a better suburb 15 years ago… it’s a very low risk strategy with a very good return. Examples like that occur every weekend.
Two biggest risks for investors
Probably the two biggest risks for investors is investment in a poor quality asset (be it property, a share or a managed investment) and the wrong strategy (or a complete lack of strategy).
A good (common) example is where one individual might own a couple of investment properties.
I call this ‘strategy risk’ – the risk that a sub-standard investment strategy will impede on your goals. Strategy is something you have 100% control over.
What can we do to minimise risk?
The answer to the above question is a separate article in itself. However, here are a few comments:
Time – the longer your planned investment period, the lower the risk. For example, if you have 30 years until retirement, you do not have to take many risks at all. However, someone with only 10 years from retirement with a relatively low asset base has a much higher investment risk.
Experience and advice – let’s return to my property development discussion above. One of the key ways developers can reduce their risk is through experience. An investor with 20 years of hands-on developing experience is going to have a greater chance of achieving a satisfactory investment return. An investment property advisor that has 30 years of experience buying property for clients will have a huge amount of market knowledge, thereby increasing the chance that they’ll pick the right property.
Strategy – the way you go about investing can change your risk. For example, something as simple as buying a property (that you plan to sell in 15 years time) in a super fund, instead of owning the property in personal names will minimise (or eliminate) capital gains tax thereby increasing your ‘after tax’ return. This correct strategic decision increases the chance of achieving retirement goals.
The single most important thing
Probably the single biggest way of mitigating or reducing investment risk is through financial planning. The financial planning process allows us to develop a smart strategy.
The next step is then to go through the strategy with a fine tooth comb and identify all the possible things that can go wrong and develop a strategy of how to address them. For example, our financial model will be able to project the income and land tax liabilities in 20 years and their affect on the client’s net retirement income.
Through changing the assumptions in the financial model, we’ll be able to see how important the capital growth rate is.
Knowing this, we’ll appoint an investment property advisor (or at least get a second opinion) to reduce the risk of buying a dud property.
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