Investor profiles and expectations in the context of investment risk

What does a rational investor consider when assessing an investment opportunity? We are likely to receive different answers from different people if we had to ask this question randomly to a cross section of potential investors.  This is a perfectly acceptable and understandable outcome that clearly reflects the fact that investors are likely to assess investment ‘opportunities’ differently depending on various factors, part of which reflect individual circumstances.

There are typically three profiles of investors – Aggressive, Conservative and Balanced. The titles already indicate what an investor fitting that profile will seek to attain in executing his or her investment decisions. The Aggressive investor is typically not after regular income but would seek to capitalise on the potential growth in the assets chosen therefore primarily seeking capital growth over time. In this respect, the risk appetite of this kind of investor is usually high and we see that such investors would typically opt for a portfolio which is based on equity securities (or equity-linked indices), particularly in companies that are expected to generate higher growth in terms of future profitability and returns. These companies may, but not necessarily so, usually associated with sectors or industries that are either emerging or may have not reached a certain level of maturity.

At the other end of the scale, the Conservative investor would typically have little to no preference towards investments which are theoretically susceptible to higher volatility and as such, the securities that one would typically go for are either fixed-income  (bonds), bond funds and/or equities providing a sustainable and visible dividend flow typically as a result of ownership of assets that are either mature and/or provide visible and stable revenue streams. A Balanced profile on the other hand, will seek construct a portfolio of investments that provides a balance between the two objectives outlined above, where steady income flows (via interests and dividends) sit alongside securities that aim to predominantly achieve capital growth over time.

In assessing risk, each of the above investors would have different way/s or criteria for assessing and quantifying risk such that each would expect a return for the risk undertaken that is most likely to be different. Assessment criteria varies but typically every investor, irrespective of tolerance levels should, as a minimum, consider characteristics such as: shareholding structure and board composition, industry, sector and project cycle, track record and profitability, strategy execution risks and finally financing ability to execute business plan. All of these factors should in some form or other weigh on the assessment every investor should make prior to investing. Naturally, an investor’s profile would then regulate the degree or extent to which the weights attached to these characteristics differ among these variables.

For example, while in my opinion every investor should consider the extent of execution risk in every project, an aggressive growth-oriented investor looking at specific sectors would likely be prepared to accept higher levels of execution risk compared to a cautious investor whose primary objective is regular income and therefore preferably no to very low execution risk as the company’s projects or plans should ideally not only be completed but also tested over time (mature phase).

In the case of a debt instrument, such as a bond, the assessment of all these risks (or lack of) should then provide investors (principally the cautious ones in this case) with sufficient information in order to determine (subjectively) whether the instrument’s ‘price’ (in this case the coupon, or annual interest rate) adequately reflects the risks assessed. Naturally there are other factors that impact this ‘price’. In the case of a bond, duration is also a key variable. Typically, the longer the duration (maturity date) the higher the coupon.

Furthermore, when it comes to a debt instrument, because of the finite element attached to the bond, one needs to assess and price also the repayment risk. In so doing, it is important to assess whether the cash generation of the business of the company would be sufficient to build up a reserve that will enable the issuer to repay the debt at the end of the term. In order to partly mitigate this risk, some issuers offer a security for the benefit of the debtholders which essentially allows the investors to liquidate the asset ringfenced as security for the repayment of the debt if the issuer is unable to meet the repayment upon maturity from its operations, cash flows or other means.

While keeping to the same example of a cautious investor assessing bonds, it is therefore crucial for them not to be conditioned solely by the ‘price’. For a higher coupon may not necessarily translate into a better deal. In fact, often, it doesn’t. Quite the contrary, a higher price is usually paid for higher risk!    Likewise, in the case of aggressive investors long mostly at shares, ‘cheap’ does not necessarily mean attractive or a good deal.  This is where the trade-off between risk and return becomes indispensable. The concept of the risk-return trade-off states that the possibility of an increase in return rises because there is an increased level of risk. As such, while the return possibilities are high if an investor can tolerate high risks, there is also the downside to that – losses. Taking on high risk may lead to higher losses and as such, risk tolerance of an investor takes on a primary role in assessing which investment opportunities one should go for. The pricing of instruments does not necessarily always take into account all the factors discussed above, or may take into account other factors not discussed but attributable to the specific issuer, and the acceptance of investors of that pricing should be only after the proper assessment of the investment opportunity.

Furthermore, an investor needs to be comfortable with the investment vis-à-vis his investment horizon. In other words, given any possible future liquidity needs or alternative investment requirements, will the investor achieve his/her desired results while maintaining this investment throughout its life (in the case of a bonds specifically) or for a sufficient long period (as recommended especially in the case of equities) while also coping with any future needs perhaps unforeseen at the time of making the investment decision? In the context of the instruments ability to be easily disposed of on the market, this is also a very important point to consider.

All investments carry some form of risk. The level of tolerance to that risk is dependent on the circumstances of the investor as we have seen. It is paramount that investors appreciate whether they consider themselves to be compensated sufficiently for these risks compared to the price they are being asked to pay for the investment.

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