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Investment Risk Management
A walk in the investment maze faces millions every day in our global trading community.
There are countless investment opportunities right under our noses. Some are good, others
smell instinctively bad. But, how are we to know if the whiff of the business opportunity is
really “off”, or does our nose fail us? The scent of prestige used to be a leading indicator for
investors. Yet, there have been spectacular failures at Andersen, Enron, Global Crossing, Tyco,
Worldcom, Marconi, Equitable Life, Swissair and Sumitomo. These show that the value of a
“big name” firm can be dubious. What have we really bought into?
Management theory, backed up by advanced information technology, would like to come
closer to guaranteeing a sound investment choice. Investment experts bring the risk and return
together. But, the danger is that final selection is still based upon prestige and not value.
It is worse when this value is exposed as fraudulent. An analytical survey of fraud in the
USA found that firms were losing about 6% of their revenues to occupational fraud and staff
abuse.1 This was estimated to be worth $400 billion. Furthermore, even good companies suffer
from strategic misdirection by the executives, and their investors may find themselves on the
sidelines watching the ship go down.We can be average at investing, and if the boat is sinking
we are even worse at influencing the decisions of large corporations. H. Ross Perot said that
trying to change the plans of the General Motors leaders was like: “Teaching an elephant to
dance.”
DREAM VERSUS RUDE AWAKENING
Modern business theory has, undoubtedly, left us richer to manage our investments. Pricing
theories and various portfolio models have provided a foundation for building future wealth.
Later and more sophisticated theories have incorporated a discount for that omnipresent element
in all business activities – risk.
No enterprise is immune to the dangers that constitute risk. Yet, risk is in itself a good
driving force to promote greater or more productive effort – the stock market feeds off two key
motivators: fear and greed.
Greed is a unidimensional factor that eggs us on to increase profits. There is no law that
defines greed as an intrinsic criminal offence; CEOs and directors have been quick to extract
as much pay and benefits from a company before they leave. Yet, excess greed comes before
a fall. They should come to fear regulator and shareholder activists’ counter-attacks. Fear is
the expression that we are about to suffer damage in some manner, primarily financial loss on
the markets – we call the damage a potential hazard. Excess fear leads to stasis, and eventual
business ruin. Risk is an ever-present factor in any enterprise, and profit is regarded as a proper
reward for bearing the risk in the first place. The notion of a risk-reward ratio comes in, and
the concept of “acceptable level of risk” is a natural result.
Risk management is the modern discipline that answered the call to handle business risk; the
prime example being company failure. Many of the failures listed above cannot be attributed to
criminal acts – corporate fraud andCEOtheft reflect sentiment that is fine for the sensationalistic
press, less so for the court room. Furthermore, a company director is rarely brought to court for
losing control of a company. It is extremely unlikely that they would have the personal assets to
come close to refunding their shareholders in full. Insurance premiums are rising, and there is
no guarantee that pay-outs are increasing pro rata; you get an insurance company’s assessment
of damage, not your costs of replacement. In view of these shortcomings, traditional legal and
insurance avenues of redress are not to be leant on as a crutch. A new look at risk management
is required.
This book targets those risk factors that threaten a loss in our portfolio value or investment.
We adopt a view of business investment as a closed project. This enables us to use a more
disciplined analysis of what governs enterprise success, and that involves project management.
We focus upon what constitutes investment risk; how organisations handle investment risk;
how we can manage investment risk better. Briefly speaking, we can bring sound engineering
and actuarial tools to examine risk and risk management in depth. Forensic accounting is
needed for a deeper investigation of a company over its statistics and corporate personalities.
These views are, oddly, absent in many business books on risk management. These financial
engineering methods are useful for the banking and fund management sector.
Everyone harbours a dream, and high profits without risk are the ideal in the financial
world. Saving is the obverse of consumption and real-life pressures come to the fore to make
achieving this dream more problematical. Returns are dropping on average, as the recent falls
in the global stock exchanges have shown. Furthermore, theworld’s population is continuing to
age, certainly so in the major developed nations. Pension funds are now reducing their benefits
and/or finding themselves under-capitalised. So, where is the dream now?
The changing demographics mean that, per capita, fewer people of working age are supporting
more retired folk. Pensions form the biggest average holding by value of any household,
more expensive than their personal house. Add up all these pensions and they form the largest
fund of private households in most Western countries. Pension fund managers and institutional
investors now exert a larger block vote upon corporations than the majority of private
investors. For example, CalPers and Teachers TIAA-CREF are large funds in the order of $148
and $270 billion, respectively. They are influential in the field of corporate governance – one
example being their near-success in scotching the HP–Compaq merger.2
Sadly, people often devote more attention to their house and all its accoutrements, rather than
choosing their investment. They pore over home furnishings or kitchen equipment, but their
choice of pensions comes last. Some CEOs, like Dennis Kozlowski of Tyco, preferred to use
company funds to help deck out his apartment in style. It is no surprise that the public patience
with modern corporate leaders is wearing thin. The CEOs’ avowed duty to shareholders is now
plainly exhibiting a tenuous link to reality.
People are beginning to experience real disappointment when their pension returns are given
upon retirement. A Robert Maxwell comes along occasionally to rob a pension fund, or an
Equitable Life fund catastrophe occurs to destroy public confidence in the future. But these
crooks are in the minority. Can the public prosecutors ever prove conclusively that there was
any criminal activity within the Tyco, Marconi or ABB losses? Given this doubt or mistrust,should the public pull all their money out of pensions and invest it elsewhere? If so, where?
This disillusioned attitude alone would lead to a strain on the pensions system, particularly
that managed by the professionals.
It is said thatwars are fought over oil; yet, the 21st century could see the real investor battling
over corporate profits, and the pension funds will figure largely. The changing demographics
of the larger older population stresses pension funds to provide for the retired. There will be a
stark separation of expectations and reality as people struggle with the net sums left to survive
on. The new defined contributions plans and the closing of some pension funds to new entrants
further splits the retired world into the haves and the have-nots.
Yet, investment funds such as Fidelity Investments – the world’s biggest fund, will definitely
continue to be numbered among the “haves”. Furthermore, with nearly $900 billion in assets
under management, such funds will move stock markets around the world through their sheer
size and influence. Investment funds will continue to exercise significant authority upon how
money is invested.
More recently, some funds have become vocal advocates for socially responsible investment,
such as the Coalition for Environmentally Responsible Economies (CERES)3 with more than
$300 billion in assets. It is not just a mere focus upon corporate profits, but an explicit drive
for accurate institutional reporting. These are to be conducted under stricter ethical guidelines
on environmental, economic and social grounds.4
Recent years have not been entirely kind to funds. Fund managers could have lulled themselves
into projecting glowing consistent returns of 10+% p.a. on the stock market. Now, a
long-term average of 4% to 6% p.a. could seem more probable. We have to link reality to a
suitable investment risk vision. Furthermore, a fall of .25% was not only realistic, but a sad
result in many stock exchanges during 2002.
We are faced with the snowballing prospect of client and business pressures to “beat the
market” in finding returns to investment. Over-eagerness is an enemy of caution, and that can
only lead to added danger or “unreasonable risk”. We look to restore a balance between risk
and return within this book.
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