An Investor’s Perspective – Part A

Welcome to the first in a seven-part series on Investing. I’ve shared previously how important it is to Learn From Your Mistakes. Some of my most key, most expensive, most valuable lessons have come from the area of investing.

We never really know all the risks to any investment we make – no matter how well we prepare or analyze. There are some valuable viewpoints, however I have learned to help mitigate as much risk as possible. I’d like to share eleven of these key perspectives with you. I share the first 6 here and the next 5 in the following blog – An Investor’s Perspective – Part B. Remember, some of the points may apply to you today, and others will be useful as you continue to grow your investment portfolio. I do however encourage you to take your time, read and begin to incorporate them into your investment thinking and approach.

1) DIVERSIFICATION IS CRITICAL

Send your grain across the seas, and in time, profits will flow back to you. But divide your investments among many places, for you do not know what risks might lie ahead.

Ecclesiastes 11:1-2

We cannot be 100% in control of the outcome of an investment, however being diversified allows you to have a more balanced return, as there will always be some losers and some winners. The reality is, no matter how smart you are, you can’t always pick winners; there’s always more risk than we can see. Diversification therefore is a smart way to protect your investments.

I didn’t pull much money out of my mortgage lending business for the first 15 years, it was growing at a successful rate and I needed to retain cash for growth. To be successful, my line of credit had to grow, so as to build the net-worth of the company; I therefore retained all the earnings. That was the nature of my business. I believe; however, you should pull out profits when you can and have a plan to diversify. The hardest part initially will be finding different places to invest. You’re probably thinking you’ll get a better return if you keep the funds in the business and you’ll get less of a return if you do something different. In addition, you know and understand the risk of your company versus other investments. Investing outside of your business may be very hard to do – but diversification’s the smarter plan.  As your business grows, learn to spread your investments to other areas. Even if where you’re putting your money generates a lower return than if you left it in your business, to me, to have diversification and more surety in your future, is worth it. You don’t have to have every dollar in your world earning your maximum returns. I know it’s harder to execute that plan because by nature we want to maximize and get the best returns.

As you diversify, I encourage you to put a ceiling/constraint on the percentage of capital you want to invest in each asset class.  Then within each asset class, establish the maximum amount you wish to invest with each sponsor.

A note on tax-free versus taxable investing

There’s a difference between tax-free and taxable investing. I’ve done quite a bit with tax free bonds, especially municipal bonds. I used to build what’s called a bond ladder, where you stagger the maturity dates, so you always have something coming due. It’s a smart way to maintain liquidity in an investment that’s otherwise locked in for years.

You can find all kinds of bonds – different durations, different structures – and that’s what makes the ladder strategy so appealing. Even though individual bonds might lock you in for a long time, having a mix of maturities means you are regularly getting access to cash without needing to sell a bond.

At one point I felt the returns were significantly better that what I could get elsewhere, especially when compared to an after-tax return. That’s the real appeal of tax-free investing, if you’re in a higher tax bracket, your effective return can come out ahead of many other taxable options. It’s worth considering and another smart way to diversify your portfolio.

2) INVEST IN WHAT YOU KNOW AND UNDERSTAND

Over the years, I have done a better job as an investor when I invest in things I know, understand and have some experience with. As you look for investments and as opportunities are presented to you; start with those that you either have an existing relationship with or have some knowledge of the particular type of business/industry.

Today I won’t invest in something unless I really understand the ins and outs on how the money is made. Most people make investments in areas they don’t know much about – and don’t pay attention. Don’t allow yourself to be a passive investor on anything. If you know something, have experience with it and understand it, you’re likely to make a better decision versus something you don’t know much about. I definitely learned this the hard way.

3) UNDERSTAND THE RISK-REWARD RATIO

Investing is all about the risk-reward. You need to understand the risk to determine how attractive the reward is. When presented with an opportunity, the return may initially look great; but on a risk-reward weighted basis it could be less attractive. Ideally, you want an optimal ratio where risk is lower and return is higher. I’d much rather have an 8% return at almost no risk, than a 20% return with a meaningful amount of risk. Even when you have third party due diligence, it’s crucial to still analyze the risk-reward ratio yourself and not rely solely on third-party reports. I’ve been burned several times on this because of failing to focus on this area.

Good questions to ask include: What is the anticipated return on the investment – both cash flow and appreciation? What is the likelihood of achieving, exceeding, or falling short of this return? Is there anything that makes the projected return more durable? When it comes to the risk of this investment- how well does the sponsor understand it? What can be done to minimize the risk?

4) DO A STRESS TEST

A Stress Test is an analysis where you identify things that could go wrong such as:

• A longer holding period
• Higher exit cap rate
• Increased operating expenses etc.

Most sponsors of an opportunity rarely provide this information, so it’s important to complete this before deciding on an investment.

In every investment, there’s assumptions made, so the way to stress test is to adjust those assumptions. For example, in a scenario we may consider taking the number of years it takes to get out of that investment or reduce any of the other positive assumptions. We create models and run different possible scenarios. If our stress testing results in a lower return than we are comfortable with, we generally won’t do the deal. Stress tests are valuable as they highlight areas that you don’t typically get to see.

5) AVOID BLACK BOX INVESTMENTS – EVEN THOUGH THE SPONSOR HAS A GOOD TRACK RECORD

A black box is any complex investment model that involves formulas to achieve returns in a desired way. More often than not, the sponsor does not fully understand the model. Investing in a black box could potentially lead to unforeseen problems.

This position came out of a lesson we learnt several years ago. My team and I were approached with an opportunity in a stock market-related area we weren’t entirely familiar with. He was a great salesman and demonstrated the investment and returns well. My team met with him several times and had a good look at the product – to the best of our knowledge. We evaluated his track record (which was excellent), talked to references and felt confident to go ahead even though we were not fully clued in on how his product worked. Within a few months of making the investment, it went south, and we lost everything.  We learned a very expensive lesson: If you can’t figure out how profits are made and where the risks are; then stay away.

There can be no secrets in investing. If whoever is promoting the investment is not an open book, where you can see absolutely everything, don’t do it. Many opportunities come along that look exceptionally attractive, offer great returns, have an incredible history and have gone well for the past 10 years. Even that is not enough to base your decision on. One must fully understand how the money is made and how the investment works.

6) DON’T BE IMPRESSED WITH WHO ELSE IS INVESTING

You may have a good sponsor, or a close trusted friend told you about the opportunity, or it may be an associate who got you in the door; either way, don’t base your decision on this alone. Don’t rely on others and what they say; be sure to do your own due diligence before investing in a deal.

Often a sponsor will try to impress you by how much others are putting in the deal, or who else is in the deal. I personally don’t find that information useful or persuasive. If we like the people in the deal, then we’ll work harder on our due diligence to see if it makes sense for us to be there.

ACTION STEPS

Good planning and hard work lead to prosperity, but hasty shortcuts lead to poverty.

Proverbs 21:5

I’m not sure where you are on your investment journey today, but I encourage you to follow the route of patience and discipline.

What are your thoughts on the perspectives shared so far? Please share them in the comments section. In the next blog we shall cover the next 6 perspectives on investing.