As a young analyst at Richardson Greenshields, I worked with a big guy with an unusual name, Pentti Karkkainen. After years as a highly regarded oil analyst, Pentti now plies his trade in Calgary at KERN Partners, a private equity firm he co-founded. I introduce him here because I've always liked his investment framework. The KERN team doesn't just look at two commodities when making an energy investment, it looks at five – oil, gas, capital, time and people.
I've kept the notion of five commodities in mind, partly because of the elegance of Pentti's presentation and partly because I wanted to adapt it to the process an individual investor goes through. What are their commodities, or essential elements of their investing framework?
My initial list had 10 items, but I forced myself to align it with Pentti's five. Like his, the first two are raw materials. The other three are how to successfully extract them.
The law of compounding is very powerful. If you invest $100,000 over 25 years and earn an annualized return of 5 per cent, the market value will grow to $338,636. Investors, whether they are private equity managers or disinterested amateurs, simply need to let the calendar work for them.
Like oil, risk can be messy, but it's not a dirty word. Indeed, when combined with time, it's the fuel that drives returns. Diversifying across the four basic risks – interest rate, credit, liquidity and ownership risk – is what investing is all about.
Notice I didn't define risk as short-term volatility, as investors most certainly are doing today and the investment industry does all the time. Risk in its truest form is permanent loss of capital, but for investors who are properly diversified, it's better defined as the possibility of not achieving their long-term return objectives. However you define it, using this commodity properly means embracing volatility, not avoiding it.
Having an investment plan that sets out where you need to get to and how you're going to get there, is the most basic of investing disciplines. (I hate to waste space on it because it seems so obvious, but far too many investors don't have one.)
A good plan encompasses the crucial components of successful investing: a strategic asset mix, a process for rebalancing and managing cash flows (in and out) and a framework for assessing performance and costs. Without one, investors are ruled by the unexpected and irrational short term, rather than the more predictable long-term.
Investing is a perverse activity and investors need to be wired accordingly. The market goes down when it's not supposed to and up when it couldn't possibly. Investors are regularly required to buy when it feels awful and sell when things couldn't be better. And they'll only know if their plan is working years later, even though they'll be barraged with meaningless, short-term signals (positive and negative) along the way. To be successful, investors need the ability and discipline to make decisions, the patience to let them play out and the fortitude to stick to a plan when they trust it the least.
Division of labour
"People" is on my list too, but I'm talking less about raw horsepower and more about alignment and co-ordination. While there are do-it-yourself investors who can do it all, most people need help with some or all aspects of the process. If they don't have the knowledge, time or temperament for investing, they need to latch on to someone who does – an adviser, money manager, friend or family member.
Investors need someone on their team who is thinking about how the overall portfolio fits together. Someone who is reading the covenants on the Telus bonds, picking between Intel and Cisco, and deciding which mutual fund and ETF to hold. Someone who will make tough decisions at market extremes. And someone who is tracking how the portfolio is performing and importantly, losing sleep when it's not doing well.
Investors don't always think about the division of labour and either pay heavily for duplication or have gaps in their roster. What's most often missing is the overall co-ordination – lots of players but no quarterback.
You don't have to agree with how Pentti and I constructed our lists, but thinking about what the essentials of your investment strategy are can only increase the chances of success.