Risk. The age old balancing act revisited.
Everything we do as humans carries some form of risk. Stay in bed, grow fat and have a heart attack. Go out exercising on your bike and get hit by a bus.
Eat and drink what you love and end up with high cholesterol. Watch your diet and feel miserable. It’s all about risk and more importantly a couple of key dynamics that are worth considering and they go hand in hand.
The first is Risk Mitigation. We hear the term all the time, mostly when politicians or stockbrokers are talking. This is a pretty simple concept. Consider a risk and then look for things you can do to make that risk lower. Also, look for things you can learn about your chosen form of risk taking that will help you rationalise the risk and perhaps put you at an advantage.
Let’s say you decide to jump out of a perfectly good aircraft. Save for a miracle or act of God you are going to die. You could chose to mitigate the risk by wearing a parachute. You might rationalise the risk by packing the chute yourself and even study skydiving to further reduce the chances of an untimely demise. Ultimately the risk is mitigated by your actions and research and the record for results when others have undertaken the same activity.
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This leads us to Risk and Return. Let’s face it, skydiving is a pretty extreme activity so why do people do it? It’s the rush of course and that’s the risk and return dynamic at its most primal. I am going to risk dying in order to feel the exhilaration of actually surviving. You are never more alive than when risking death I think they say. Sounds crazy to me but each to their own. High risk (death) = High return (wow, I didn’t die)
As I am sure you have anticipated this all leads into the Risk dynamic as it impacts financial services, investments and business more broadly. If you are contemplating a decision relating to your finances or business it’s wise to consider what I have outlined above. Interest rates are a perfect example. To fix or not to fix. Stay variable and risk getting caught in a fast moving rising rate environment. Pay a higher rate to fix and lose the advantages of lower variable rates and cheaper debt. My advice is understand the key drivers of rate movements, do your research and at least make an informed decision.
Investment decisions are always risk and return based and should be thought of in the context of our earlier sky diving example. Cash in the bank is low risk and low return while speculative mining shares are probably at the other end of the scale. Remember, when investing there are two risks at play, capital and return. It’s one thing to get a lower return than you expected but quite something else to do your dough altogether. Somewhere in the middle are business investments such as management rights. I would argue that this business model represents one of the few instances where the risk and return dynamic is out of kilter.
It is not unusual for management rights operators and investors to see a return on their capital (return on equity) in excess of 20%. At this rate of return one would assume a very high risk is being taken by the owners of the business. In fact, industry insiders who have done their research, understand the business model intimately and appreciate the operating environment have come to appreciate the attractiveness of the industry for investors with many seeing the risk and return dynamic skewed in their favour. They have mitigated the risk by taking the time to understand the business and have developed the necessary skills to pick a winner.
So it’s all upside then? Not quite. Like any going concern business, management rights are exposed to a raft of future risks including changes in legislation, occupancy demand, exchange rates and volatile regional economic conditions. The fact is that an investor could not only lose their return but also their capital if things went badly wrong. In a worst case scenario personal guarantees could be called up by a lender and serious money could be lost.
The key is to mitigate the risk through education, research and wise choices and ensure that return is appropriate reward for the risk taken. With legislative support, banks lending aggressively to the industry and corporates acquiring management rights at record values it seems that some pretty significant players have already come to their conclusions.
Disclaimer: This is not investment advice. The author is not a financial advisor and does not hold an AFSL. Seek independent advice whenever considering an investment of any kind. Return percentages quoted are for illustration purposes only. Pack your own parachute.
Mike Phipps F Fin
Director | Phippsfin Pty Ltd
ACN 139 124 673
Australian Credit Licence 364314