Interview with John Cronin, CFA, by Francis Katamba
Francis Katamba – John, why do you put such a strong focus on investment planning before the investment process?
John Cronin – Well Francis, before people rush to buy an off-the-shelf investment product, or decide to make direct investments in the financial markets; they really need to consider their current financial circumstances and where they would like to get to – their goals. By doing this they can reduce their risk of buying an investment plan or building an investment portfolio, which is not consistent with their current situation and/or their financial goals.
Francis Katamba – So how would you recommend going about the investment planning process?
John Cronin – You have to be methodical; you must go through a process of self-analysis, even if you are using the services of a financial adviser. Self-analysis is important as it helps you develop an understanding of your own situation. Further, in addressing the issues raised in your self-assessment you can assist your financial adviser in designing an investment plan that best suits your personal circumstances, goals and preferences.
Francis Katamba – Interesting, so this methodical process of self-analysis can help you make better decisions. Can you outline the self-analysis process?
John Cronin - The methodical process has seven elements, the first two concern setting up your risk and return objectives, the remaining five are your:
- liquidity needs,
- time horizon,
- tax circumstances,
- legal and regulatory issues, and lastly
- unique circumstances.
The last five are potential constraints on your investment strategy, affecting the type of investments that you may choose. Today, I am mainly going to talk about the process of setting up your risk and return objectives, which can actually be quite a fun and thought provoking process.
Francis Katamba – What are the key points in setting risk and return objectives?
John Cronin - There are two elements here. First you have an individual’s willingness to take risk, which is based on personal experience. Second you have the individual’s ability to take risk, which is based on cold analysis. The tricky issue is reconciling the individual’s willingness to take on risk with their ability to take such risks, where the two differ.
As I said an individual’s willingness to take risk is built on experience, which brings us into the realm of behavioural finance. In shorthand, behavioural finance is the study of why people don’t invest rationally. There are many types of irrational investment behaviour; the two best known are loss aversion and biased expectations.
Loss aversion is the tendency for people to feel the regret of their losses more deeply than the pleasure of their gains.
Francis Katamba – Why does this matter?
John Cronin - There has been a lot of research in this area and what emerges is that people’s financial decisions are often swayed by emotion rather than rational analysis and this means that they do not always act in their own best interests! So for example, behavioural economists have observed that the tendency of people to react more strongly to losses than to gains, which is known as an “asymmetric tendency” can lead to people holding their losing investments longer than they should, and selling their winners too early.
This behaviour has been identified as one of the most common reasons why many investors suffer poor investment returns. The solution is to take a completely dispassionate approach and assess every investment on its expectations and whether those expectations have changed – fundamentally – on the arrival of new news.
Francis Katamba – What other kinds of behaviour commonly lead people to make poor financial decisions?
John Cronin - As I mentioned, there are many different types of irrational investment behaviour. Loss aversion is one of the most common, but another is having “biased expectations”, which results in misplaced self-confidence. Some people are overconfident in their approach to investing, whereas others can suffer a serious lack of confidence.
The over confident feel they have better judgement and insight than they really have, which can lead to poor investment decisions.
Francis Katamba – Can you provide some practical examples of how this might manifest itself?
John Cronin - Sometimes people convince themselves that they have influence over uncontrollable events, such as predicting the outcome of a toss of a coin. This character trait can lead to overoptimistic expectations of investment returns, where judgement is biased on overoptimistic feelings rather than assessment of the facts. Look at how many people became self-declared property tycoons because they bought and sold houses during the property boom, only to become unstuck when house prices faltered and fell in the subsequent house price crunch. They developed unrealistic expectations that strong house price inflation was the new norm. They overlooked several controlling factors that influence house prices, such as affordability, economic prosperity and the level of employment.
An indication of just how widespread overconfidence is in the population is the famous survey of US drivers, which found that 88% of those interviewed believed they were safer road users than the average American driver.
Francis Katamba – You have explained how overconfidence can be a problem and you have also touched on how people tend to react emotionally to losses. Before moving on from this point, could you just expand on how lack of confidence can also negatively impact on people’s financial decision making abilities?
John Cronin - Yes, there are people with little self-confidence; who may appear to be at less risk, because they cannot begin the investment appraisal process and therefore would not normally make any risky investments. However the outcome can be very similar to that of the overconfident. Sadly these people often end up investing into booming markets just as they are reaching their peak, this is known as the bandwagon effect. They then panic sell, deeply feeling their losses, vowing never to do it again, which is called the snakebite effect. When they come to reconcile what has happened, they conclude that they invested against their better judgement, known as hindsight bias, and never learn from their mistakes. Like the overconfident, the under confident also suffered from the busting of the property market, because they were some of the last buyers before house prices started to slide.
As you can see behavioural issues can knock an investor off making rational investment decisions. Hence self-appraisal of your behaviour traits is a key part of the investment planning process, as it permits a clearer understanding of your ability to take risk.
Francis Katamba – Having assessed my attitude towards risk what sorts of factors should I consider in order to weigh up my ability to take risk?
John Cronin - The determining factors that dictate your ability to take risk weigh upon your age and how much you can contribute towards attaining your savings goals. A person in their 30s who can contribute 25% of their monthly income towards a pension can take more investment risk than a person in their 60s who can only set aside 10% on a limited stock of accumulated wealth. The former is more able to withstand adverse market movements, because they have a long contribution period ahead of them and a greater likelihood of earning the long term expected return on the financial markets in which they invest.
Francis Katamba – How would I then go about measuring the risk of a particular investment?
John Cronin – Well there are a number of ways to measure risk. One common method is the absolute measure that uses standard deviation of return. Standard deviation may have been something that you came across at school. In this instance, you don’t need to know how to calculate it, but just be aware that the larger the standard deviation of return the larger the investment risk.
Francis Katamba – So assuming I have gone on the internet or, dug out my old school books in order to calculate the standard deviation how do I apply this to an investment strategy?
John Cronin – All investments have an expected risk and rate of return. What this means is that you might expect an investment to go up by 10% in any one year, but because this is a forecast, you can expect a range of outcomes either high or lower than your expected return. This range of outcomes is your investment risk. Hence investment risk is not only getting a return that is less than you expected, but also getting a return that is more than you expected. By using the standard deviation of return (the value that is produced from the calculation) you can establish the probability of the expected range of outcomes using some simple maths.
To expand a little, financial models predict that 68% of all expected outcomes lie in a range that is one standard deviation either side of your expected return. 95% of all expected outcomes lie in a range two standard deviations either side of the expected return. Using this knowledge we can work out that if an investment is expected to appreciate by 10% in one year and has a 5% standard deviation of return, there is a 68% probability that your return at the end of the year will lie in a range between 5% (10% - 5%) and 15% (10% + 5%). However if the standard deviation of return is 10%, then, applying the same principles, you could expect a range of returns between 0% (10% - 10%) and 20% (10% + 10%). In other words, the higher the standard deviation of return the more risky the investment return. Knowing the standard deviation of return is therefore a very useful tool for getting an idea of how risky a particular investment is.
Francis Katamba – OK, so the principle seems to be that your risk objective sets your return objective?
John Cronin – Yes you are almost right, as there is a strong link between risk and return, your risk objective largely determines return objective. However there are other factors to consider. Firstly how much return do you need? Is that expected return realistic? Naturally, you can’t hope for high returns that are risk free!
Francis Katamba – Let’s say I wanted to buy a house but, I needed to save and invest in order to have enough money, how would I apply the principles we have discussed?
John Cronin – Well, suppose you want to buy a house in two years’ time and, your savings are 15% below what you expect to pay in two years’ time, then the target annual rate of return needed to fill the gap between your savings and the purchase price is in the region of 7.5%. Fortunately due the effect of compounding, the fact that after the first and subsequent years your savings are larger by the return earned in the previous year, the compound annualised rate of return needed over two years is slightly less at 7.24%.
Therefore to fill the gap between your savings and the purchase price, you need an investment capable of earning at least 7.24% per year for the next two years that carries an acceptable level of risk. The challenge here is to identify investments (assets) that can reconcile the return objective with an acceptable level of risk.
By way of example, let’s look at the historical returns and standard deviations of return for two classes of asset: UK government bonds and the UK equity market. The UK government issues many types of government bonds (known as Gilts) with different interest rates and different maturities. The UK’s Debt Management Office provides at full list on its website. The long term historical rate of return and standard deviation of return for UK gilts, with a 10 year maturity, is 5.5% and 13.8%. Therefore in any one year you can expect with a 68% probability of earning a return between minus 8.5% (5.5% - 13.8%) and plus 19.3% (5.5% + 13.8%). Equities have a higher expected return and a higher standard deviation of return, 9.4% and 19.9% respectively. Using the same formulae again an investor has a 68% probability of experiencing a range of returns between minus 10.5% (9.4% - 19.9%) and plus 29.3% (9.4% + 19.9%). As you can appreciate these results demonstrate the different risk and return characteristics of UK Gilts and UK equities. However I must caveat this statement by stating that past performance is no guarantee of future returns.
Both the historical returns on ten year UK Gilts and UK equities illustrate that they capable of delivering the required return. However the current yield on 10 year Gilts is 2.73%, which is well below the 7.24% required return. It is unlikely that 10 year Gilts will achieve the required return because interest rates are close to their historical lows. Further, if interest rates return towards historical averages, then investors face a capital loss. Because when interest rates rise, the price and capital value of bonds fall. Given the associated expected range of returns that we discussed above, then both 10 year Gilts and UK equities are too risky (too volatile) to be used as investment vehicles to help buy your house, because of the risk of losing a substantial amount of the capital sum invested. An alternative strategy, which provides a high degree of capital protection because it matches the time or investment horizon to the pending house purchase, is the purchase of a UK Gilt with a two year maturity. Unfortunately the yield on two year gilts is 0.44%, a long way below your required rate of return.
Going through this exercise demonstrates that it would be wiser to buy a smaller house or put more money aside in savings, because the investments that meet your return requirement exceed what would be an acceptable level of risk, given these specific circumstances; the chief investment constraint being the short time horizon. You can go through a similar exercise with retirement planning, where you might find your investment horizon is much longer and hence your ability to use more risky assets to take advantage of potentially higher expected returns increases.
Francis Katamba – Are there other issues you should consider?
John Cronin – Yes indeed, once you have established your risk and return objective, you need to consider the five investment constraints: liquidity, time horizon, tax concerns, legal and regulatory issues and your own personal choices. The first two, liquidity and time horizon directly influence your ability to take risk.
Liquidity is your need for readily accessible funds, money set aside for anticipated near term expenditure or for precautionary reasons, such as unemployment, sickness or domestic emergencies – like the need to buy a new boiler for your hot water system. These readily accessible funds could take the form of money in your deposit account, or some investment which is safe and accessible at short notice. Naturally the low risk nature of liquidity reserves means they do not earn a high return. As a rule of thumb, households should aim to have the equivalent of three months of salary or wages set aside as precautionary liquidity. If the amount of money set aside for precautionary liquidity represents a large portion of your portfolio, then your overall ability to take investment risk is constrained, compared to if your liquidity reserves represent only a small portion of your overall wealth.
Your time horizon, also affects your ability to take risk. The house purchase example I mentioned earlier illustrates a relatively short time horizon, in that example the desire was to buy a house in two years’ time, hence the time horizon, the period between now and realising your investment goal is two years. As I mentioned earlier, a short time horizon limits your ability to take risk. Whereas if you are investing for a retirement that is 30 years in the future your time horizon is long; hence you more able to bear short term adverse movements in stock and bond markets, and likely to earn the long term expected return.
Francis Katamba – You mentioned three other investment constraints: tax concerns, legal and regulatory and lastly personal choices. Can you expand on these issues?
John Cronin – tax concerns are simply the taxes that you may be liable for on your investments. The point to recognise is that taxation on investments reduces your net return. Some investments are taxed on income, some on capital gains and sometimes both. Consequently this is a consideration for the type of investments you make. However care must be taken not to distort your portfolio by investing in assets which lead you to exceed your overall risk objective. In Jersey, where the tax rate is 20%, 80% of something is worth considerably more than 100% of nothing.
Legal and regulatory constraints are often put in place to protect your interests. For example certain investments which would be regarded as high risk are only available to investors who can prove that they have wealth that exceeds a certain threshold. UCITS funds are required to manage risk by being diversified and being virtually prohibited from using loans to magnify their returns – both up and down – known as leverage.
Personal choices are restrictions that the investor places on their portfolio. For example some investors invest with an ethical style, refusing to invest in companies that produce alcohol, tobacco, defence equipment, or provide gambling services, damage the environment or use child labour. Another personal choice could be a requirement to hold investments that generate an income, for example to fund retirement. Either way, personal choices affect the type of investments that can be held in your portfolio.
Francis Katamba – Briefly summarise how investors should set about the investment planning process?
John Cronin – Investors need to be methodical in their self-analysis. An investor needs to recognise the behavioural weaknesses that could cause them to embark on a less than optimal investment strategy. An investor must balance their appetite for risk with their ability to take risk; this depends on their age and relative wealth. They should plan with an investment horizon in mind, to help calibrate the level of investment risk they can bear in their investment portfolio. They should make evidence and facts the source of their investment decisions, not feelings. Lastly, they should always have a precautionary reserve of readily available funds for rainy days.
Biographies
John Cronin is a Chartered Financial Analyst (CFA) with over 20 years of experience as a financial markets professional. During this time he has worked as a stockbroker, stock analyst and portfolio manager.
Francis Katamba is qualified lawyer, with over 10 years of professional experience in corporate finance and commercial law.
Both John and Francis are senior managers in the policy section of the Jersey Financial Services Commission.
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