I consider myself lucky to have gone to university and, for the most part, I idolised my finance professors. These learned folk were prepared to impart their knowledge and teach me and fellow students all we needed for a successful and illustrious career in accounting or finance.
It is only with hindsight and a successful, though perhaps not exactly illustrious, career that I can appreciate the shortcomings of my professors and humbly suggest some additions to the curriculum to prepare students of the future better. I'm not saying there was anything wrong with the theory - indeed the capital asset pricing model and modern portfolio theory have held many an investor in good stead for decades. It's just that the theory needs to be tweaked to take account of the real world to be truly effective.
The first modification I suggest is around the language used to discuss risk and return. The phrase 'in order to achieve a higher return an investor must tolerate a higher risk' is too glib and is too often skimmed over by students who think 'yes, yes, I understand that'. They invariably don't.
Risk means different things to different investors as does the notion of 'higher' returns. If risk and return are considered without reference to one's investing personality and goals and time frame, trouble can quickly ensue.
Some investors put too much emphasis on the risk part of the risk/return trade-off and invest so as to avoid any prospect of their investment falling in value, even if for a short period or to a limited extent. This approach can ironically result in a higher risk - the risk of not achieving sufficient returns to meet their investment goals.
Others play down the risk element and become greedy in the search for a quick road to riches. They ignore the chance that their sure-fire bet will fail or they do not diversify, hoping just one successful investment will give them the returns they seek.
The reality is every investment has risk and every investment has return. A successful investor will firstly understand the risk inherent in every investment they consider; they will look to balance their risks and returns across a portfolio of investments so, even if time proves them wrong in their estimation of risk and return, they won't lose their shirts.
The second and related amendment I suggest is about diversification. This is another finance term most people feel they understand, particularly when simplified by reference to lots of eggs in lots of baskets. But diversification needs to be explained as different sorts of investments, rather than a whole bunch of investments. Six rental properties do not make a diversified property portfolio, even if they are in different suburbs.
Successful investors will aim for geographical diversification - shares in international companies rather than just familiar New Zealand companies - and sector diversification as well as asset class diversification across low-risk assets such as cash and bonds and higher risk assets such as shares and property.
To give an indication of true diversification, can I respectfully suggest to the professors they highlight the 10 sectors in the stock market, according to the Global Industry Classification Standards? The 10 are financials, information technology, health care, consumer discretionary, industrials, consumer staples, energy, materials, utilities, and telecommunication services.
Owning shares in Mighty River Power and Meridian may have generated great returns in 2014 but provided exposure to only one of the 10 sectors. Had they performed badly in 2014, owning shares in one of the other nine sectors might have helped mitigate the risk.
The last modification relates to price and value; it can be a hard concept to get one's head around. It is human nature to think that price equates to value and that a low purchase price means you have bought well, whereas when a price falls after you purchase means you have overpaid.
Legendary investor Warren Buffett tried to explain the difference by saying that price is what you pay, while value is what you get. I think value is like beauty - it's in the eye of the beholder. It is incumbent on every investor to understand the underlying, inherent value of an investment rather than simply using the price as a gauge.
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