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Everything Good Comes in Three

 

There are three levers to successful investment management. First, we have the risk management and no, this is not an exercise in calculating the cross-correlation coefficient of an optimised portfolio. Rather, it is where we decide how we are going to roll the dice. A bit of this, maybe a bit of that, some stocks, some bonds and some alternative investment funds. Whatever we decide, this is where we are at risk. Many people obsess about this decision and I can understand why. After all, more than 90% of our investment returns are a function of the very things we do here. Be that as it may, remember the underlying truth: to make money, we have to take risk. Which also means, that so long as we take risk and don’t do anything too drastic (like betting too much on the same thing), we should be able to make money.

 

Moving on, the second lever of sound capital management is, well, leverage. In a world of efficient capital markets, interest rates are the blood lines that makes the system hum. Do we borrow, do we lend, and at what price, drives not only the world economy but also how we use our capital most effectively. These days, we do not make any returns on our cash, thanks to record low (and even negative) interest rates. As such, there is a large opportunity cost to holding large amounts of cash and not putting it to use somewhere else. On the other hand, if cash is so cheap why not borrow some and buy a bit more of what we want? And therein lies the trick. If we love low mortgage rates to buy our houses, why not do the same with our other investments. It would actually be inefficient not to. Of course, there is the risk that our investments also go down, but that’s why they call it a lever, to be used with extreme prejudice.

 

Finally, we have the currency management, and this is where it gets really scary. If things are random and they either go up or down, how much do I bet and what does it cost me to play? There is nothing more awful than currencies and you will lose, because the house always wins, but let’s take this one step at a time. First of all, you have to decide what kind of money you want to hold. Be it Sterling or Euros or Japanese yen, you need to choose a base currency, so you can also measure your returns. In other words, you need a reference point to which all other currencies compare (that’s why they trade in pairs). From there, you need to decide how much you want to hold in one versus the other. Too much in others and you could lose if your base currency goes up, but too little and you could lose if your base currency goes down. Oh, and whatever you decide, the hedging costs are running at more than 2% per year at the moment for any non-US dollar investor. 

 

Putting it all together, there are an incredible number of things that we have to manage when investing our monies. And then there is the utter brutality of our efficient global capital system. If you get it wrong, somebody else wins and if you overpay, it is someone else’s gain. Expect no quarter in this world, so make sure you adjust your levers wisely.

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