Should Corporate Investment Decisions be Based Solely on Numbers?
When making investments, investors usually consider less risk as favourable – the lower the risk, the more lucrative the investment. However, the rule of thumb is, the higher the risk, the higher the returns. Every investment is inevitably exposed to some degree of risk, regardless of how well-informed or carefully considered the corporate decision that drives it, is. But what is investment risk, and what should companies be keeping a lookout for when they decide to invest? Investment risk is the probability of losses from any investment the company makes, due to a decline in the value of the item invested in, such as stocks, bonds, real estate, mutual funds, commodity futures etc.
Investments are tools which help firms achieve their financial goals; where a company invests, therefore, is tied to what goals it wants to achieve. It may invest in stocks, shares, property, bank products and mutual funds for one reason, but choose to invest in things like options, cryptocurrencies and commodity futures for other reasons. Each of these has its own characteristics, and knowledgeable investors are aware that they need to assess each investment possibility carefully to determine the extent of the uncertainty of obtaining the returns expected by the company’s shareholders. Knowing what factors to consider when investing will help them apply appropriate mitigating measures.
Risk is a critical component in the assessment of the prospects of an investment; risks may also involve the possible loss of the principal sum invested. Companies looking to make investments therefore should follow a management process that will firstly determine the firm’s needs and assess its risk tolerance before deciding how to allocate its investment funds. The investment management process includes the planning process, and the determining of the company’s portfolio objectives. A firm strategy should be in place with close and comprehensive monitoring and reporting. This should also be the case when portfolio objectives are being determined.
What types of investment risk should organisations be wary of? There is market risk, which covers equity, interest rate and currency risk; and liquidity risk. There is also concentration risk, which is the risk of concentrated investment in the area where the organisation seeks to invest. Another is credit risk, where the issuer may be unable to pay the principal or decline in creditworthiness. Other investment risks include reinvestment risk, inflation risk and horizon risk – the risk arising from the inability to hold on to an investment due to unforeseen circumstances.
With so many factors to take into account when setting in place an investment risk management framework and policy, the procedures for timely assessment and evaluation of performance of the types of assets being invested in are imperative. There should be clear accountability, lines of authority and separation of duties, to ensure transparency and good governance when it comes to investing shareholders’ funds. Part of the framework involves setting the portfolio management process which must take into account factors like risk tolerance, liquidity issues, taxes, legacy concerns and time horizon of the investments.
These may also be applied towards further developing or refining the firm’s investment strategy. Setting all these components in place together with the appropriate measurement and review mechanisms will go a long way towards supporting the firm’s long-term investment plans. Taking risk may be an integral part of business, but it is the responsibility of the board and management to ensure that everything has been done to the best of their abilities and the constraints of the firm to manage disruption, maximise returns and avoid outright failure. The strategy for investment risk management should include diversification, consistent and long-term investing.
Diversification will entail investing in various assets such as stocks, bonds, real estate and others which align with the organisation’s objectives. With diversification, if one investment does not perform as expected, the others in the portfolio may be able to make up the shortfall. Consistent investing – investing small amounts at regular intervals – also known as averaging, may be another practical recourse, particularly in markets where prices fluctuate. Long-term investments usually give higher returns than short-term ones, which tend to have more volatility. But what else should organisations consider when making investments?
They may want to keep a careful eye on emerging risks, particularly if they have investments in emerging markets; these may be affected by currency risk. Emerging markets may experience social, political and economic uncertainty which may create or contribute to market volatility. These may also adversely affect the sustainability of the company’s investments in that market. With increased globalization, companies today face more threats than ever before. The importance of appropriate risk management has grown in tandem; managing risk may be even more important than making a profit, particularly where a company has made long-term investments.
Every investment and investment strategy comes with risk. Investors know that 100% accurate forecasting is not possible. While corporate investment decisions should certainly take numbers into consideration, there should not be an over-reliance on these. Identifying risks and making the numbers work requires open minds and a focus on future possible scenarios. Risk will always carry negative connotations with it, and elements of uncertainty. Understanding its limitations and applying the tools available to mitigate risk and safeguard corporate investments may be the best, most effective means of dealing with the challenges that come with uncertainty.