So in this video, we’re going to discuss risk profiling and its role in portfolio construction. So this is going to be quite a deep dive. So if you want the short version, look at our summary version for risk profiling. But today I’m again joined by Calvin. Good morning. So Calvin, all right, so we’re going to go through risk profiling. We’re going to go through a little bit of how we approach risk profiling because it’s one of those concepts that’s really poorly or even misunderstood and misused a lot, I think. Fortunately, it’s evolved a bit over the last couple of decades. But really, I guess, what we mean by risk profile is how do we work out how to construct investment portfolios based on individual client needs, for want of a better term, right? So we can think about risk profiling as, okay, so why do we do it, okay? And we can get into the risk investments and those sort of things, but actually the principal reason why we do risk profiling actually is to manage two risks in particular, one being behavioural risk, how people, investors behave, and the other one being liquidity risk, because the nature of the pricing investments can change depending on their liquidity. So we’ll go through that in a bit of detail. Now, how do we go about that? Well, like most things, we’re gonna follow a whole bunch of principles, principles being ways of behaving that we know work, right? But ultimately what we wanna end up with is we wanna end up with two different types of assets that we call growth and stable assets. And we’ll see how they interact to give us a investment portfolio that can be an approach to customising for individual people’s sort of needs, right? Okay, so as always, we need to start with some definitions ’cause we want that precision and clarity, right? So what do we mean by risks or risk, right? So risks, we define risks as the probability of not achieving a desired result. Okay, now, often people when it comes to risk and with investments, they talk about the risk of losing their money. And that’s one type of risk. We’ll talk about capital risk or credit risk and so on as we go through. But we need to think in terms of the risks, anything that creates a probability of not getting the result we want. Okay, so it’s the result that determines whether something’s risky or not, not the thing itself, if that makes sense, right? So, and then we can think of it, the risk that we take is actually the sum of all the risks, the sum of those probabilities. And this is really important because some risks amplify each other, some simply just compound, some negate, mitigate, whatever. So risks interact to change the nature of the risk that we take. But what do we mean by investing? Well, our definition of investing is what we’re trying to do with investing trying to maximise our probable future purchasing power. So first of all, it’s a future purchasing power. What resources can we acquire with these financial resources in the future? We can define terms as we go through, but it’s in the future. And we’re trying to maximise the probable, because as we’ll talk about in a bit of detail, is all futures are probabilistic. We need to understand, well, what’s those probabilities and can we actually change those probabilities in some way because that will change the nature of the risks that we face, yeah? And I wanna make a distinction between investing and speculating, right? So you can think of investing as maximising the probable future purchasing power, whereas speculating is maximising the possible future purchasing power. So I might win Lotto, okay? And so that might give me the maximum potential, right? But that also might give me the greatest degree of variability. Whereas investing is more about maximising the probable. Does that make sense? That’s the difference when we talk about investing versus speculating, right? – Because Lotto, it’s not actually putting a, well, a probabilistic, like a statistical weight on the different outcomes. It’s just going, “Oh, this could happen.” So it’s like, it’s pitting the, like if you’re speculating for Lotto, is it fair to say, you’re like, they’re saying almost there’s a 50/50 chance like you would win the lotto as opposed to you lose the lotto? Is that? Well, no, so you can think of it in terms of what’s the result I’m trying to get. So if my result is trying to maximise purchasing power, so let’s take probable and possible out of there. Now both of those, I want to maximise future purchasing power. Okay, so do I invest or do I speculate? Well speculation will always give you a greater potential. You can’t take a, I don’t know what a lotto ticket is, $100, right? to turn $100 into 50 million, but there’s no investment that will do that, right? Over any, you know, short space of time. That there just isn’t investment. We’ll talk about why that’s fundamentally not possible as we sort of go through this, but you can think about how do I turn the price of a lotto ticket into a $50 million windfall? That’s not possible, okay? It is possible to turn that into, turn a $100 ticket into 50 million. In fact, people do that all the time, okay? Because winning lotto is really, really unlikely for any one person, but really, really highly likely for any one lotto draw. Does that make sense? So the chances of you winning lotto with your one lotto ticket is, you know, depending on the nature of the lotto, but somewhere around 50 million to one as a general rule, right? But someone wins lotto. Okay, so you can say, what’s the probability that lotto will be won on any individual draw? I don’t know what that is, but it’s probably somewhere like, I don’t know, 40% or something like that, or maybe even higher. But most of the time, like lotto jackpots, ’cause sometimes people don’t win, but, and again, depending on different sweepstakes we’re talking about, but most of those sweepstakes things, someone wins the jackpot, which is why it’s so attractive, ’cause if no one ever won, no one would ever play. But, so someone does win. So you gotta separate the, can it be done? Absolutely, it can be done, okay? it is definitely possible to turn a $20 ticket into a $50 million win, that’s possible. But it’s not probable. Whereas investing is saying, okay, well, I wanna maximise the probable return. And the probable return, if I look at the probability or the return on that probability from a lot of ticket, that’s a really poor investment because the likelihood is really, really low they get anything. In fact, I’m almost certainly gonna lose 100% of my capital, right? So it’s really poor investment, but it could be a great speculation. And the same thing is if I’m, we’ll get into this when we talk about trading versus investing, right? If I’m out there buying and selling shares or options trading or derivatives or cryptocurrency or anything that’s highly volatile, that is, that I can speculate on, okay? Because I can speculate either rapid or fairly significant price movements, or I can amplify those price movements ’cause I’m buying something that’s a relatively stable blue chip share, but I’m using derivatives like options to highly leverage my exposure to them. So if Commonwealth Bank goes up by a dollar, I can make a huge return. Does that make sense? So we would call that speculating, or trading essentially, right? As opposed to investing, and we’ll talk about the different sides. But that’s, if you think about it from the fundamental point of view, when I’m investing, I’m trying to maximise my probable future purchasing power, right? Versus timeframes, because it’s future, it’s important, and the probability of return, very important. When it comes to speculate, the timeframe’s important, okay? And the possible return is what’s important, okay? So I’m probably not going to speculate on commoditised blue chip shares, okay? But I might turn that into a speculation using things like highly leveraged derivatives to turn that into something. Does that make sense? – Yeah. – Because now the possible return is much higher. So there’s a difference between investing and speculating. Okay, so how is this traditionally done and what do we think is kind of right and wrong with that? So the first thing to appreciate is, historically, once upon a time, it was really there to help manage participation risk. Are you the sort of person that’s gonna freak out prices move too much and the amplification. We can talk about that as we go through in terms of the quantification of that. But really it was designed around the concept of answer a bunch of questions to say how much price volatility can you tolerate? I.e. we’re trying to manage sort of behavioural risk, right? Whereas our approach is much more based on what will maximise your probable future purchasing power? That’s what investing is, okay? So again, that’s not really as necessarily is focused on how much price volatility can you tolerate, because we’re looking at probability. So you might be able to tolerate a huge degree personally, you’re a very risk tolerant person, if you like, you’re an aggressive risk profile under the traditional definition. But if your timeframe is very short, right, then a lot of things won’t provide a very good or very high probable future purchasing power, if it’s a six month or really short time, Does that make sense? So the fact that you personally might have no problem tolerating, you know, very volatile investments, like, and we use cryptocurrency as an example, right? So I don’t mind, it fluctuates all over the place. So yes, but if your timeframe’s really short, then the probability of that fluctuation being really poor, providing you a really poor return is very high. That would make it a bad investment. – Yeah. – Does that make sense? So timeframe can be an important part of that as well. Okay, so how do you manage this? Okay, well, there’s really two major types. One we call, categorises what we call participation risk, right? So that is a combination of behavioural risk and also we’ll talk about sequencing risk as well. And sequencing risk thinking of the order at which your returns come. So not just your average return, but when do those return come and how does that impact your return on invested capital, for example. And behavioural risk is simply how well will you, How will your behaviour drive how much you participate in that, does that make sense? So you can think of behavioural risk as your decision on participation, do I buy more, do I get out, do I sell, how do I behave buying and selling in the market itself, okay? And sequencing risk is how much capital do I have at play when the returns come, because the variation returns might be great to poor, and on average they’re okay, but then what order they come in does that change things potentially as well? And then there’s the actual return itself, right? So the return itself, again, you can slice this a number of different ways, but there’s three main ones. One is what we call credit risk, okay? What is the likelihood of me getting the money back from whoever I gave it to, okay? Now, in a really simple sense, you know, if we took it that from, say, in credit markets where we’re just lending money, it’s really just the capacity of that person to repay. But it also spreads to, well, if I’m going to invest this in equities, right? Then are they listed on exchange? Are they chess sponsored? Are they privately held? You know, what assurity do I have that I have legal control and right to the actual thing itself, whether it’s essentially a share certificate or whatever? Right? Because often people, often, often, often where people have lost money in investing, it’s not necessarily because the underlying investments were or weren’t a good thing, but the credit risk. And I don’t necessarily mean someone ran off with the money, it’s just the availability to make sure that that money, your entitlement to those assets was clear. Was there an independent custodian? Was it subject to some sort of regulatory regime that’s an APRA or ASIC or someone’s looking after it? Or is it, I lent some money to a mate or I put some money into someone else’s investment, private company or something like that. what risk do I have of actually getting legal access to my capital back? – So it’s just, it’s not just for lending, ’cause like when you say credit risk, my mind just goes immediately to lending, but it’s broader scope than that? – It is broader scope than that, yeah. So that’s the simplest version of that, okay? Or do I have a legal contract with someone to say, you owe me this much capital under these conditions to get it back? So that’s when people talk about credit risk, that’s what they can traditionally talk about. But it also comes back to when you’re using, say, investment platforms or super funds or other sorts of entitlements to something, you also need to look at, well, who’s behind those things? There’s been some examples of where investment structures have collapsed historically, and it’s been a disaster because in the end, when administrators come in, one of the first jobs they had to do was work out, well, who’s entitled to what? Does that make sense? So it’s really important from our perspective when we’re looking at using an investment product provider is that all those things are taken care of. we regard that to sit in the credit risk scenario. At the end of the day, a client’s portfolio says they own this number of BHP shares but if we can never establish that legal entitlement to that money because someone doesn’t run their accounts properly or what came through on their online portfolio doesn’t match reality because the administration’s poor or whatever, it doesn’t necessarily have to be just pure fraud, right? It could be just a case of you’ve got sloppy accounts and we don’t really know who owns what. Does that make sense? So we look at that from a credit risk perspective. There’s nothing wrong with the investments per se, but it’s our entitlement to that. Then there’s the market risk, i.e. the nature of things we’re buying. Are we buying into, are we taking enterprise risk ’cause we’re buying into companies? Are we taking traditional credit risk because we’re lending money to borrowers? Or other various types of markets. So what’s the risk of the market itself? And then there’s what we call specific risk, the specific risk of the thing that we’re buying. So in a simple sense, you might have the market risk of the Australian share market, and the whole market might move up and down or sideways or whatever, but then BHP has a risk all onto itself. Does that make sense? So the market might be going gangbusters, but BHP’s losing money, hand over fist, and going broke, for example. Conversely, BHP might be going spectacularly well know the market model will be going very well. Okay, is there’s a difference between the market risk and the specific risk we need to worry about as well. With specific risk, are you removing market risk from that? Because like, for example, BHP could kind of go up on a, that’s a bad way of putting it because I know we’re about to talk about volatility, but say over a long period of time the market kind of goes on a general rise and BHP kind of just gets swept along with that to an extent, with maybe some more specific risk tied in with that, but like the general trend is upwards, not because it’s doing particularly well, just because everything else around it’s kind of going upwards and that’s pulling it along. Would you, like in specific risk, do you say we’re not considering market risk that plays into that or? How do you weight the two of them you mean? – Like, does specific risk include market risk if you’re just looking at like BHP as a single entity by itself, for example, or are you removing market risk from that? – So generally you’d look at the two things completely separately, okay. From the point of view of saying, okay, that BHP has market risk because it’s part of a market and will be affected by those things. But when you talk about specific risk, you talk about the risks that are specific to BHP versus anything else you could own in that market, if that makes sense. – Yes, yes. – So, and we’ll talk about this when we get into the specifics of that, right? But as a general rule, one of the reasons why we advocate for active management as we think the best way to invest is precisely because it’s the specific risk that ultimately determines your result. You know, and there’s lots of, you know, sayings, you know, most of them attributed to Warren Buffett, you know, it’s a rising tide floats all boats, Think of that as the market, regardless of how leaky the boats are, right? Whereas, and you can think of the boats themselves as specific risk, okay? But the other thing is you only find out who’s been swimming naked when the tide goes out, right? So again, it’s a specific risk, ultimately matters, ’cause if we think about it, it’s about future purchasing power. So if BHP continues to make, we’ll get into the driver of these, but essentially continues to make growing sustainable profits year on year on year on year, it won’t really matter if it’s in a market where most other companies aren’t doing so. And some fantastic is that we can delve into that in a bit of detail, maybe at a different time, but you could look at that very specifically and say the Japanese share market over the last 40 years. Okay, Japanese share market’s only now, you know, it’s still down from its highs, right? So, but it was, you know, 50% underwater for decades. very advanced economy, some great global companies have made significantly increased profits over that period of time. But if you were a Japanese share market investor and just bought the market, you’re two generations in and you’ve still done your money sort of thing. Does that make sense? So yeah, specific risk matters way more than market risk, ultimately in the long term, but again, timeframes matter because market risk can bring you undone when the specific risk is fine. So again, so yeah, so it’s all about probability, right? So this is our standard distribution curve. So you can think of this as an average and then your standard deviation. So just, you know, without getting too heavy on the maths, we’ve got one standard deviation from the average, okay, is covers about sort of 68% of all probable results, right? And we go to standard deviations, then we get out to sort of 95% basically. So we don’t need to worry about this too much to understand that the greater the standard deviation, the more variability there is in return, right? So do we want a very wide one or do we want a very narrow curve, right? Because we can change the nature of the curve. That matters. So we don’t, we don’t, we just want to know what the average is. We also want to know what the potential standard deviation of that is as well, because that can change the probabilistic sort of outcome, right? Okay. So why does all this probability matter? Well, because it turns out behaviour risk is by far the biggest risk that an investor faces. Why do we say that? ‘Cause it’s borne out statistically over and over and over again, and I’ll use these examples from the Dow Bar study. So again, just to clarify, the Dow Bar study is a study that’s run on US stock markets, but essentially what they do is they look at one, two, three, four, five-year returns, all the way through to 20-year returns, okay? And every year it comes out and says, “Okay, well, what is the average investor’s return “over that period of time in mutual funds?” I think it was managed funds in the US, versus the market. So specifically what they’re doing is they’re looking at saying, okay, well, the XYZ fund over this period of time did say 10%, okay? So anyone who invested at the beginning and was still there at the end, same number of units, got a 10% return. However, Calvin’s account, he bought and sold units along the way. So what was Calvin’s actual return over that one, two, three, or 20 year period, right? So Calvin’s return might have been better or worse than that market return because the weighting of money, this is that participation risk we’re talking about, right? Calvin participated more when markets were great and less when markets were terrible, or vice versa, he’s gonna have a better or worse return than the market. Does that make sense? And this is relatively consistent, but these are three of my favourites. So this period, if we look at the 20 years ending 2005, so this is 1985 to 2004, so what happened during that period? We had the crash of ’87, so that’s Black Monday, 25% loss in a day, sort of 45% in a month. We had the ’90s recession we had to have, you’ll remember it well, no doubt. – Oh, so well. – We had the bond crash in ’94, ’94 would be one of those relatively rare years where everything went down, okay? No credit, the only thing that made money was cash, ’94. We had the Asian crisis in sort of ’97, ’98. We also had the collapse of a hedge fund called Long Term Capital Management, which everyone seems to have forgotten about, which is quite famous ’cause it was like a hedge fund full of more PhDs and the smartest people ever, and they were making these ridiculous returns for three or four or five years prior to that and were just crushing the market because they’d cracked the code. And then the market volatility blew out because Russia defaulted on their debt and the Asian crisis happened and blew the volatility out and blew up their model and they went broke. So, but everyone seems to have forgotten about that. Then we, so that was the late 90s, then we had the tech wreck in the early 2000s. So a lot happened, right? Very busy time for markets, probably as bad a period as there’s ever, 20 year period there have been. If we look at the return over that time though, the S&P 500, so this is the 500 largest company, capital weighted, right, similar to our sort of all ordinaries index or ASX S&P. So the return actually over that period was 13.2%. So really, really strong returns for that period of time. So you drop into a comery in 1985, you wake up in 2005, you look at your portfolio and you’re just like, holy dooly, this is what a great time to be alive. Talk to someone who lived it down and go, what do you mean? We had this crash in ’97, we had this recession, we had blah, blah, blah. And the average investor through that period of time, 3.7%. So drop into a coma, do nothing, you get 13.2. Average investor ends up at 3.7. And the compounding difference of that is you end up with nearly five times the money, right? Just by not doing anything. Okay, let’s take 2011. So this starts in the middle of that recession we had to have. Again, you got the ’94 bomb, crash, you got the Asia crisis, you got the tech rate. But now you’ve got 9/11 and the GFC thrown in there, and you’re pretty much just coming out of the depths of the GFC here in 2010. So the market bottomed in March 2009, so still in the depth of the GFC. Again, now the market returns only 9% of that per time, still pretty good. Average invested 3.8. And again, 2019, so here, tech rec, 9/11, GFC, et cetera, just prior to COVID. But again, so this was a particular, and the reason I picked this period is ’cause this is a particularly low running. Lot less things went on, lot lower return, everything went wrong, much higher return, but during that period, the market only did 5.6%, okay? And the average investor 3.8. So it’s almost like no matter what the market does, the average investor’s gonna pump out 3.8%. They’re just like, it’s almost like they’re fixated on inflation and a bit, right? So, and so the difference there is, okay, The penalty wasn’t as high here because the market return actually wasn’t as high, but that had nothing to do with anything really. But what you can see here is, so this is investors just not participating fully in the market for that period of time. Does that make sense? And it makes an enormous difference to their return. And what is it, why is that? What does that look like? Well, again, if we contrast, so this is a bit busy, but just to take you through, all this is looking at is one year versus 10 year returns by different asset classes. So here we’ve got global equities, We’ve got domestic being Australian, we’ve got global property, global infrastructure, so on and so on. And what this shows you is there’s obviously not really any clear patterns over one year, okay? All right? Now, it’s also to keep in mind, this is from 2000 through to sort of 2020. So during this period, we do have some interesting periods ’cause the GFC’s in the middle of this, right? So, and what the GFC did is really change the interest rate profile. So in this period, as opposed to most other 20 year periods, you see a lot more good years for bonds because we had interest rates go from relatively high to terminally low. Okay, so this would be a much better bond 20 year period than most periods. But you can see if I run this out to 10 years, and so this is again, 10 years, so 10 years ending in 2000, through the 10 years ending here, you can see now we’re getting a bit more consistency in the colours, right? So now we are getting, you know, up here we’ve got a lot more, you know, domestic equity, still a little bit of fixed interest in there, bit of infrastructure, and also a bit of property. So domestic, right, so this is real, think of this as real estate trusts, right? So your Goodmans and your Westfields and some of those, particularly through here, this is Westfield. But what, I guess the point here is you’re getting things like cash and domestic fixed interest, are getting much more regularly at the sort of bottom of the table, if you like, right? So you’re getting a bit more sort of separation. And again, the point of this isn’t to focus on which particular asset class, other than to say, as a general rule, you’re gonna see growth assets at the top of here and you’re gonna see defensive here over a 10 year, whereas in one year, it’s gonna be all over the place, if that makes sense. The other thing to keep in mind is this is a little bit of a sort of like a sample bias in the sense that, Obviously, because this is a rolling 10 year, anything that’s done well through these periods is probably still gonna continue to do well here because it’s had those, it’s had seven or eight or nine of the good years. Does that make sense? And so it can take a while for things to drop off and you can see that if you look at the, you know, the orange and red sort of drop off here as a result of these great early years through here and through here, they disappeared and, you know, there’s not a good use to balance them up. But the point of this, I suppose, is just simply to say that the difference between one and 10 year is quite stark, but you do start to see a bit more consistency over the 10 year, the longer term period, which is why they talk about time in the market, right? Okay, but how does that play out from an actual risk perspective? We talked about what’s the probable returns, okay, for future purchasing power, okay? So again, this is looking at the 20 year data in a slightly different way again, but here we’re looking at different portfolios. So here is your traditional conservative, so it’s basically almost no shares and property, no growth assets, right? Here we’re talking about no cash and fixed interest, it’s all growth assets, right? Over a 20 year period. And this is looking at, again, range of returns here, but again, think of this as a two standard deviation. So 5% of returns are worse than this, okay? And only 5% of returns are better than this, and here’s your average in the middle, okay? So think of this as pretty much worst case, this is pretty much best case scenario over 20 year periods, right? And so you can see as a conservative investor, and say, “Oh, well, I don’t wanna take any risk, right? “So I’m gonna be conservative.” And then, “What’s my worst case scenario over 20 years?” Well, I’ll get sort of 2%. Whereas if I go down here and say, “I’m gonna be an aggressive investor, right? “I’m gonna be all growth, okay? “What’s my worst case scenario over 20 years?” Well, it’s about 1.7% per annum, okay? Whereas a growth investor, it’s two. So in other words, you can see across here, now that compounds a little bit over time, But for all intents and purposes, over 20 years, in an absolute worst case, there’s not fundamentally any difference between being a conservative investor or a high-grade investor. But you can see here, obviously, the best gets significantly better. And you can see even what happens here to the median. So this is the middle return. So my average return, if I’m in median, so median being the middle as opposed to average, but you can think of that as the compounding that’s gonna put me in terms of an average return, right? So I’m most likely gonna end up here somewhere. And so the most likely return I’m gonna get as a high growth investor is going to be considerably greater. And again, here’s why growth assets really come into their own in the long term is because there really isn’t any risk, right? When we talk about the risks to capital, the risks to that capital from a worst case return perspective is essentially the same. Okay, so again, looking at the sum of risks to add up to my total risk, if my goal here is to increase my probable future purchasing power, then clearly I want as much of this as I can get my hands on. Okay, because there’s no downside probability, but there’s plenty of medium to upside probability, if you like. And to look at how that sort of plays out in a slightly different way, this one just looks at the compression of that over time. So again, 20 year data, again, different sort of risk profiles, if you like. Again, think of this as percentage of growth assets, so shares and property versus bonds and cash, being defensive, right, or what we call stable, right? So again, and again, the point of the business are much the absolute numbers per se, but again, a conservative portfolio, worst 12 months, call it 20%, best 12 months, sort of low 30s. A conservative, worst is sort of barely minus. And very quickly, getting out to sort of five years, you can start to see that conservative portfolios, they always cover themselves within a few years, right? Whereas high growth portfolios or growth only portfolios can still be negative over that sort of five year period in the absolute worst case. So again, this is our five percentile. So only 5% of returns are worse than this. Again, this is our 95. So only 5% of returns are better than this, right? So this is again, two standard deviations or 95% of returns live between these two colours in each case, right? So you can see here that again, very rapidly, once we get out to sort of 10 plus years, the worst return I got, even if I got in the absolute worst time into 100% growth, 10 years down the track, I’m not really that much different to if I’d gone into a fully conservative portfolio. Does that make sense? And again, this is a point to point. So I only invested once and I put all my money on the same day. – Yeah, well, actually I do have a question about that. And it came from like the Dow Bar study where they were looking at the S&P 500 versus the average investor. The S&P 500 is a dynamic measure in the way that NVIDIA, for example, wouldn’t have been in there in the 1970s by pure reason of it didn’t exist in the 1970s. And so taking this example then, you’re saying we put all our money in like one day, just bought a whole bunch of stuff and have left it for 20 years, the market composition is gonna look very different. – Yeah, so it’s important, I guess, to look at, well, what specifically are you buying? Is that the question? – Yeah, well, like, are these data, like the Dow Buy Study, for example, or this, is that taking into account the fact that some growth things disappear? Nokia is maybe a good example of that, where, like, it was a growth asset, but now it’s completely gone. – Okay, so maybe just talk the definition around growth assets, right? So by growth asset, okay, and we refer to shares and properties growth assets because the income they generate, their potential to generate cash flow, grows over time, okay. As a result of that, over time, their capital price, the share price, right, will also grow over time. That’s not the only reason share prices move though. We’ll talk a bit about the composition of that as we got a bit deeper into the slides. But yeah, so that Dalbar study is comparing the index itself, which you’re quite right, the F and P 500 changed drastically over those periods. However, it’s a legitimate measurement because you can buy that index. So you can invest directly in that index. And therefore you could have got essentially that index return. Does that make sense? So it’s a reasonable proxy. It’s something you could have bought. Now, are all of the underlying investor returns the same? No, as in it’s not comparing people who bought the index to people who only bought index funds. It’s not comparing that, it’s comparing all, as many mutual funds and get the data for, okay? But I guess the point is, investors are making active decisions and predominantly the ones they’re making is participation. That’s by far the big, because it’s not like during that period of time, all active funds returned 4%, 3%. Most active funds returned some, even though you can consistently find that most active funds, depending on when you measure them, but it’s fair to say it’s pretty easy to find somewhere between 50 to 70% of active funds don’t beat the market. Okay. However, none survive that underperformance. perform that poorly. I can’t imagine, maybe there’s a handful of, because the investors don’t pay any attention at all, but no one who’s actively investing is generating a 3% return actively and doesn’t know that they are. It doesn’t know that they are in the sense that they’re not making active decisions that’s contributed. They didn’t chuck it into an Australian share fund that did 3% when the market did 30. No one’s done that. Does that make sense? So yes, on average, and again, so it depends on which marketing team you’re rooting for, right? So you could, we talk active versus passive. We’ll discuss that a bit more as we go through, but that itself isn’t an argument for active versus passive in specific versus market risk, ’cause again, the S&P 500, think of that as purely market risk, ’cause it’s a collective of the market, right? Where specific risk is owning Nvidia instead of the rest of the market, or owning Tesla or Microsoft or any individual stock or collection of stocks, right? So think of the specific risks as how far you deviate away from the market by essentially not owning the entire market. There’s a degree of risk differential between that, okay? And the reason we like active, okay, is precisely because of that, with active, the likelihood of that future purchasing power, and again, we’ll go through this a bit more as we go through some more specific examples, the like of that future purchasing power being there is higher because we own things that make money. Okay, now, that might mean that one of the trade-offs to that is we are now, you may be faced with probabilistically not getting as high a return as you could have, okay? So this is one of, I think, one of the things people misunderstand when they look at active versus passive “Well, I could have just bought an index “and would have got a better result.” And there’ll be periods where that’s true for, as I said, generally sort of 50 to 70% of active managers, depending how you measure them. I would argue it’s relatively easy to find active managers that are very close to market return, okay? The reason we advocate primarily for active, overly wedded one way or the other, but gun to my head and make me pick, I’ll take an active manager, because an active manager is more likely to own investments where that profitability is sustainable, and therefore they’re not going to turn into the Japanese share market. An active investor would have owned Toyota and whatever along the way, right? Not just buying the index, okay? And again, the Japanese share market’s, I think a great example of where index, no one likes to talk about how the index investing can go horribly wrong. Finland’s another great example back when Nokia was 70% of its index, right? We had News Corp 25% of our market back in the late ’90s before the tech boom, right? And they sold newspapers. So there’s lots of examples where index investing is a poor idea, but it’s a legitimate other thing you can buy. Okay, and if you buy a broad enough index, one could argue you’ve got enough diversification into that economy, and as long as that economy’s okay, you’re gonna be okay. But I guess the point of the comparison here is when we talk about growth assets, we really just mean assets where their future earnings growth is gonna drive their value. And because it’s uncertain, you’re going to get a degree of uncertainty in the short term, and we’ll talk about how liquidity amplifies that as we go through. But think of this here as that uncertainty in future earnings trajectory. – Yes. – We know it’s gonna go up on average, but we don’t know it’s gonna go up a lot and we don’t know it’s gonna go nowhere for a few years and then go up, it’s gonna go down for a few years and then go sideways. That variability is very sensitive in the short term. But what this shows you in the long term, it’s not very sensitive at all. You get the general version to me. And again, I guess the point of this graph is to show that over time, the worst case scenarios are virtually indistinguishable. But everything else is better the more growth assets you have. Does that make sense? Okay, so again, it’s really important to understand what is our actual goal? Okay, so we come to investing again, we’re not speculating, we’re not trying to give ourselves the highest possible return, okay? We’re trying to give ourselves the highest probable return over the timeframes. And again, what we’re looking at here is we’re talking financial assets, we’re talking about future purchasing power, but at what future? So we can break that into a couple of different timeframes. I’d say three general. First of all, we have what we wanna store, right? We wanna store our purchasing power, that’s really short term, maybe one to two years maximum. Think of that as what would go in the pantry, so you don’t have to go to the shops every time you wanna cook. So that’s savings, savings is just delayed expenditure. Whereas we also need to then preserve some so that we’ve always got that when we have it. Think of that as almost like your canned goods. Grab them out of the pantry, they’re not gonna go off, you can have them there for a couple of years, they’ll all be fine, they’re gonna be preserved. They’re not gonna get any better, but they’re also not gonna lose their value over time. And so stable assets, assets where we can at least match inflation. You can think of it in that sort of way, right? Where we’re not taking money. So that we move into things like credit, enhanced credit, those sorts of things, some degree of fixed interest, but again, only where our long-term capital’s not really at risk, right? And that can happen in bonds, right? Where capital can be at risk, not just from a credit risk, but also from an interest rate movement perspective as well. So think of the stable as buying time for our growth assets to have generated that increase in earnings. So that either we have that cash flow now that we can spend, right? ‘Cause it’s a future purchasing power. Or at least we had times for the earnings to grow sufficiently enough that the capital price, the share price if you like, or the asset value has risen somewhat in line with that. And that again, think of those graphs compressing over time. we’ve given ourselves that five to seven years plus to know that even if we do have to sell some of these growth assets now to fund our resources, right, our purchasing power, the probability of that return being at least positive, if not reasonable, is much, much higher ’cause we’ve given it that timeframe. Does that make sense? So that’s really the sort of three slices, if you like. Think of this as cash in the bank. Think of this as the war chest in funding liquidity. And then in reality, we wanna have our growth assets all in here. So going back to what we looked at at the beginning, said fundamentally from a probable return perspective, we wanna have all our money in growth assets. Now, the problem with that, as we saw from that short-term volatility is that if we’re gonna use growth assets for this short term, we might end up having to sell those assets at a time when their values, in some cases, severely depressed. And so we’re now going to liquidate and realise those losses, ’cause those units are gone. So think of these as buying the time for that average return to player. And so it’s constructing a portfolio that is the right combination of those things based on the amount of capital you have, the timeframes, the amount of cashflow, i.e. how much future and how much purchasing power are we talking about. That’s the key determinant of what a portfolio should look like for you versus me. Not, well how do you answer these questions on a risk profile in terms of your understanding of volatility, does that make sense? So that that’s not important, it’s important consideration for behavioural risk ’cause as we mentioned earlier, behavioural risk is if it’s gonna come undone, it always comes undone, sorry, it almost always comes undone there and it’s way more there, okay, and it’s way more acutely. You sold out at the worst possible time and then by the time you realise the market’s going back up again, and we look at that when we do the principle of loss inversion, you’ll never get that money back again, right? Whereas if you just had have stayed in, right? But by the same token, if you have to come out in the short term, right? Then now you’re speculating on that return. Even though they’re blue chip shares and their long-term credit and earnings growth risk is really low, the market and that liquidity can bring you undone in the short term. That’s something you know, and therefore it’s going to reduce your probable return. Does that make sense? So, this is how we construct a portfolio. So in theory, everyone who has the same amount of capital with the same timeframes and same cashflow ends up in exactly the same portfolio. Does that make sense? Regardless of their risk tolerance, ’cause their risk tolerance is driven by their purchasing power, which in the example I just gave is exactly the same. The fact that one person has a high tolerance for, let’s just say risky behaviour when someone else is really conservative, Neither of those things are effective because markets don’t care about your feelings. Okay, they’ll do what they do and the result you’ll get have nothing to do with that side of things. But we do need to recognise that behavioural risk, right? So… – So would you say that there’s a better way to deal with the behavioural risk than like the classic risk profiling? Like so this presents something where we can tell people, Like this is how we think you can enhance your purchasing power to the best that like the financial instruments we have at hand can provide. But obviously like there’ll be people who are still nervous or check the share market every day. – 100%, so we’ll go through how we overlay that now. But this, I guess the point here initially is to understand that at the end of the day, constructing a portfolio should be based on the goal of the portfolio, okay? Now, recognising that behavioural risk is the elephant in the room, okay? But the recommendation’s gonna be, if your goal is this, here’s how we’re gonna go. By the same token, you might say, I’m happy to speculate, take unlimited risk. And our response to that would be, fantastic, off you go. That’s what getting into business for, or however you wanna trade that, it’s up to you. That’s not what we do. What we’re interested in is we’re interested in investing. We’re interested in maximising probabilistic future purchasing power. Those things don’t do that, that’s why we don’t do them. Not because we don’t think that they’re fun or could be cool to do, or we can’t apply any expertise to that. We can, we choose not to, because we’re in the business of, in this case, we’re in the business of maximising probable future purchasing power. And that has nothing to do with you. That only has to do with your timeframe and amounts relative to what markets can deliver. Does that make sense? So again, in theory, everyone ends up looking the same from that perspective because they have the same goal. Okay, now, how we manage their transition into that recommendation, that’s what we’ll do with the behavioural risk. So in theory, you might come a really aggressive, aggressive risk profile versus a really conservative profile from our perspective, you could end up with exactly the same portfolio. Because this is what suits the goal of that, even though this particular person would be happy to take much more speculative risk. And this person would be happy to have way less volatility in their portfolio. There’s ways you can hide that, right? Or you control their behaviour, right? So that we limit the behavioural risk, right? So again, summary, think of risk as a total risk, right? Of the sum of the risks, those individual risks we take and how they aggregate, right? And risks are the probability of achieving a desired result, right? So if we look at, again, credit risk or market risk, specific risk, sequencing risk, there’s a whole bunch of risks. But it’s the combination of these, how they come together to give you the probability of achieving your goal, okay? So again, gross assets, we talked about, they’re assets with earnings growth, i.e. their ability to generate future cash flows is greater. Okay, now, again, keep in mind, this ability to generate, I’m not saying these things necessarily pay that cash flow, yiddy yiddy yi. – I mean, that’s why it’s a probabilistic return. – Well, not just that, but also, that might be the nature of the structure of the investment. So for example, we might say, okay, we’re happy to own a company that’s a startup, that’s a early stage of growth, or has spending like a mining company, for example, is going through a lot of capex, ’cause it will mean that their future earnings potential are much greater, but their dividends might be really, really low for a very long period of time. Okay, we’re not interested in saying, okay, well, we won’t not buy it because the yield is low, or you get little cashflow today, that’s a portfolio construction issue to deal with. If the total future earnings potential of that company is higher than another company, we would much rather own that. Does that make sense? So we’ll talk a bit about that when we talk about yield versus income, but it’s that growth in earnings that matters, that potential, whether they’re paid out as dividends or not, less concerned, ’cause there’s lots of tax reasons and some of that can come into play as well, is the potential for that earnings growth, right? And a stable asset is an asset with stable earnings. ‘Cause if the earnings are stable, the prices tend to be. Okay, and again, we wouldn’t extend that as far as companies with stable earnings, ’cause there really isn’t such thing as companies with really stable earnings, but there are types of assets that can have relatively stable earnings. But there’s some combinations, we’ll go through an example of those when we get to the example section of how that can be changed just with the dynamics of liquidity, for example. But we’ve gotta think of value as the benefit divided by the price. Okay, so very different measurement when we’re talking about lifestyle assets, for example, but here we’re talking about financial assets. So the benefit here is simply that earnings profile. How much cash can we get out of this thing in the future? And therefore the price we pay for that is gonna be a huge determiner of that value. Because the benefit we get out of that future earnings, it’s gonna be what it’s gonna be, okay? We can guess that to a degree, okay? And once we’ve had that guess A versus B versus C, the price we pay for that’s going to be a far bigger driver as to whether, you know, how accurate we can guess that earnings growth profile. Does that make sense? So we’ll always tilt towards trying to buy a cheaper earnings profile than a higher growth earnings profile because the variability can be so great and the price can vary so much with some of those more high growth orientated investments, right? – Yep. – We can think of our participation risk, right, as the effect of our behaviour on the number of investment units we buy. We talk about that with the Dow Bar study. Either I think it’s a great time to buy so I’m throwing as much money in as I can, right, versus I’m nervous and I wanna pull money out of the market. Okay, that’s essentially what that Dow Bar study is kinda looking at. And what we know from history and what that Dow Bar study shows is people tend to put more money in at the worst of times and take money out or not put money in when times are bad, or either returns seem to be lower. Does that make sense? – Yeah. – So that behaviour risk really is the effect of the timing of investment unit ownership, right? So how much do we own and when do we own it? But we can think of liquidity risk as the relative depth of markets for units, okay? So really good example of this is, say, residential property versus shares in CBA. Okay, if you’ve got 500, you wanna buy or sell 500 CBA shares, there’s hundreds of thousands, if not millions, of CBA shares available on the market any given day at a relatively tight price range, okay? So your liquidity in CBA is really, really high. You’re not going to drive the price of CBA buying and selling your 500 shares. Even selling a few hundred thousand dollars worth of Commonwealth Bank shares, you’re not going to move the needle in terms of the price. Most, the most motivated sellers are ready to meet as long as you’re willing to take whatever the prevailing market price is, okay? But if I take, say, a residential property, you’ve only got one house, right? Your house is your house, okay? And so there isn’t the degree of divisibility, there’s not a whole bunch of exactly the same houses that you could buy or sell alternatively. And therefore, the depth of market for that house is essentially 100% to zero, right? You can buy the whole house or you can not. You can’t buy a little bit of it or sell a little bit of it. Does that make sense? And so where you have less liquidity, right, either because in a particular share, let’s take a really small company where maybe there’s not a lot of shares trading, then the price is gonna move a lot more because the depth isn’t there. I’m gonna have to convince more and more, if I wanna buy, I’m gonna have to convince more and more people who don’t ordinarily wanna sell, to sell, and therefore I’m gonna have to push the price up to do so. Similarly, if I wanna sell more and more, then I’m gonna have to push the price down ’cause I’m gonna have to convince people, more and more people to buy. Does that make sense? So, and you can think of, you know, how do I, what we sometimes refer to as a law of risk conservation, right, well, how do I minimise that total risk, right? And there’s three things, we talk about this in our, in protection, we talk about how do we deal with risk, and there’s really only, there’s three things you can do, right? You can transfer risk, okay? I can essentially get insurance. Someone else will take that risk can make me whole if it turns out I suffer a loss. I can mitigate it, I can take action to make sure that the probability or the severity of the impact of that risk is reduced, okay? Or I can simply accept it, right? I can say, look, you know, the excess of my car insurance, you know, I’ll move it from 500 out to 1000 because in reality, if I’m gonna get something, if I’m gonna have an accident, it’s gonna cost me 10 grand, it’s really gonna cost me much. And if it’s just a ding, that’s I’m not gonna worry about fixing it, or I’m happy to pay the six or $700. The difference between 500 and a thousand is not much, where it’s gonna produce my premiums enough that I’m happy to take that risk. Is that right? I’ve accepted that risk, right? Okay, so how does that relate to portfolio construction? Right, okay, so remember, our goal here in portfolio construction is investment returns aren’t simple 5%, 4%, whatever that return is year to year to year, okay? And so you often get people questions, say, “Oh, how’s my investments doing? What’s my investment return? And the answer to that is, well, I can tell you what it was calculated historically based on growth and income received, but that’s not really gonna tell me anything about what the return profile is gonna be going forward because again, it’s not a return on the capital invested. Okay, it’s a combination of the movements in price and whatever earnings actually get paid, right? But you can think about, what am I trying to do in portfolio construction? What’s my goal, right? is outcomes are probabilistic. So what I’m trying to do is change the nature of those probabilities. So again, we’ve got two different probability curves here. One has a average return, you know, in the sort of seven or eight range with a very high standard deviation. As you think, okay, well, in an ideal world, if I could maybe narrow that standard deviation, make my range of returns narrower and move my average slightly, now I’m gonna get a better average return, and therefore I’ll compound better, but I’m also gonna get less variability, right? So I’m gonna get less really bad ones, all right? And in fact, that’s really essentially the way you can look at what a portfolio construction is trying to do, right? Because if I look at my extremities, right, for every bad return, there’s a great, for every great return, there’s a bad, right? That’s a combination of the extremes of those probabilities. So again, that gets to that speculate versus invest scenario. So we’re gonna speculate, I’m gonna be out on this bleeding edge out here, but that means I’m just as likely to end up down here. Okay? Whereas if I say, okay, well, what if I just simply try to move the needle slightly and try to get rid of these really poor ones? Okay? And so by definition, good returns is, well, anything positive compounds well, okay? And then if I can keep it in a narrow range, I can maximise my likely return, okay? And then compound that, I’m gonna end up with that highest probable future purchasing power. Does that make sense? Obviously this is relatively simplistic, but we’re going to, by doing so, we are going to forego potential. Okay? So we’re never going to be top of the charts. By design, we’re eliminating these possibilities because these possibilities open you up to these possibilities. Okay? So you can think of that as sort of, you know, we’re trying to reshape the distribution curve is what the ultimate goal of portfolio construction. Okay, so how does that play out short-term versus long, short-term headlines versus long-term results, okay. So let’s look at what actually drive results. And we’ve used this, I’ve used this slide in a few different things, but it’s a great one, so I’m gonna stick sort of with it, right. So again, here we wanna look at yield versus earnings growth, okay. Yield being what percentage of the capital invested do I get returned as income in the first year? – Yeah. – Okay. So in this case, we’ve got a 15-year term here. We’ve got Telstra versus NAB, both yielding on average 9%. So what that means is, so let’s say So for every $100 invested, every year I got $9 in dividends on average. – Is this the 15 years leading up to the investment? So like, what does it say, 2003? – So 2003 I invested $10,000, okay? I had that $10,000 invested over 15 years. And then every year I looked at what dividends did I get and what percentage did I get versus what the capital value was at that point in time. – Yeah, so but it’s not like the 15 years prior, it’s the 15? No, it’s for the 15 years holding it, yeah? So every year, on average, my average yield, average income divided by the capital value average that year, okay, was 9%. Computer share and Ramsey were three to four. So you think of these as low yield and think of these as high yield. Okay, and again, this is most prominent when people make the mistake of moving into retirement, saying, “Oh, well, I need income. “I didn’t need income before. “I can take these low-yielding investments “’cause I don’t need the income. like you just reinvest that, I don’t need it when I’m young and I’ve got plenty of time. But as I get older, I need income, I need yield, right? So I’m gonna go for yield. And then this looks at how much actual cash did you get. Okay, so in Telstra’s case, over the 15 years, you got about 13 and a half thousand, NAB you got 12, ComputerShare gave you 21, and Ramsey 35. So the physical amount of cash flow you got out of Ramsey was three times what you got out of NAB, okay? even though NAB was, well, almost three times the yield on average through that 15 year period. Does that make sense? So this looks like an income stock, but paid you a third of the amount of cash flow, okay? Now, why is that? Well, the reason is relatively simple, ’cause it all comes down to earnings growth, right? So here, while you see a sell versus Telstra, another example. So starting back here, we put $100 into, this is in 2001, into CSL and Telstra. Telstra basically at the end of that 20 year period, Telstra shares were now down to 70 bucks, you lost 30% of the value, and the current gross yield on my initial investment was 4.2, initial investment, right? Whereas CSL, my $100 had turned into nearly $1,800, and my yield on my initial investment is now 17%. Okay, so again, the yield in that year is still very low, but on my initial investment, 17, because the amount you can see here, the amount of cash flow I’ve got has just gone under through the roof. So it’s that earnings growth that’s the ultimate driver of return, even though Telstra, through that period, is a very high-yielding company. Okay, so this is a bit busy, so we’ll walk through this a bit carefully, but this is a great graph, I think, for showing you how that number of growth changes, okay, and makes things look better or worse than they really are, if you don’t understand what’s driving that share price number, okay? So what do we got here? So the gray bit here, right, which is this bit here, this is how much return. So this is the S&P ASX 100, so the top 100 largest companies in the Australian share market, okay, for this period from early 2000 to 2018, okay? So here you’ve got the dividends. As you can see, they’re basically, they don’t move much. Percentage is very solid. We’ll get into the variability in a second. In this light blue here, you’re getting return, the absolute return, from earnings per share expansion or contraction. So above the line here is positive return, below is negative. So this is earnings per share. So the earnings per share of companies in aggregate across the 100, they’re making more money. Okay, this is leading up to the GFC. Here’s the GFC period and so on, right? So you can see earnings growth here, 20 plus percent getting up to 30 percent. Very, very, very strong earnings growth. Okay, and here’s your capital return. So this is your 12 month rolling return. So this is dividends plus share price, okay. So you can see here that most of this, here, now you’ve, oh I’m sorry, there’s one last factor, this is what we call P expansion and contraction. So P being price earnings ratio. So that’s the price, share price of say Commonwealth Bank divided by its earnings. Okay, in other words, how many years worth of earnings do I need to buy Commonwealth Bank? So a PE of 20 means it’d take me 20 years worth of dividends at that rate to buy the stock at that price. So $100, $5, okay, I’d have a PE of 20. $5 worth of earnings ’cause 100 divided by five is 20. Okay, now, PE’s expand. CBA might be trading at eight times earnings, might go out to 15 times earnings. the earnings hasn’t changed with the share prices. Goes from eight times to 16 times earnings, then the share prices doubled, even if the earnings haven’t changed. Similarly, if it went from eight to four, the share price would halve with exactly the same earnings. Does that make sense? So the earnings can go up, and the earnings per share stays the same. If the earnings double and the earnings per share stay the same, then it’s gonna double, okay? So you can look at those two things. So are earnings going up, and that’s what’s pushed the price up? Is the PE changing? In this case, the PE is going up. In these cases, the PE is coming down. Okay, and so it’s detracting from return. So your total returns is black line, and that’s the sum of the dividends, the PE expansion and contraction, and the earnings per share expansion and contraction. So companies make more, okay. So anywhere where we’re going up because of this dark blue, you can think of that as a market getting ahead of itself. We’re just expanding that price earnings ratio. Earnings aren’t changing. Anytime you see this light blue driving things up or driving things down, you can think of that as fundamental. Companies are making more or less money. Does that make sense? – Yeah. – Okay, so you can see here that dividends clearly have nothing to do with volatility. Because, can you see the dividend crash? There’s a little bit of a slump here because banks, apparel banks, they weren’t allowed to really cut their earnings back. In fact, if you go to the COVID time, they actually sort of did that, right? So this is graphs of before, but you can see here that there is no earnings crash. Sorry, there is no dividend crash, sorry. Now, earnings, you had an earnings crash. Here’s your, earnings went hugely negative. So here you got this huge, before the earnings drop, you get this huge contraction in PEs, and that’s what driven the market down. Then the earnings follow, okay? So this is the market guessing that earnings gonna be horrible, this is it turning out to be true. This is the market going, well those days are over, and you can see that the PE expansion, even up to 80%, came well before the earnings recovered, okay? You can see along here, it’s sort of the market’s kind of guessing this is getting a bit ahead of itself, getting a bit ahead of itself, right? Getting a bit ahead of itself, and then, okay, now it really has, right? So you can see this major wave around the GFC period. Here’s expectation earnings will be better, here’s earnings being better, expectations earnings will be worse, kicking in almost sort of straight away, right? Okay, and then you’re getting this sort of wave of change. So you can see here that it’s the dividends having almost nothing to do with the volatility in the market. It’s all to do with the expectation of earnings, right? And this, you can think of this as the expectation of earnings and actual earnings and the interplay between those two things. Does that make sense? And this is why it doesn’t matter how risk tolerant you are, time matters in the market, because it’s very difficult at any of these stages to know where you are. It’s relatively easy here. Like back here, it was relatively easy to know that we were in expansion phase and earnings growth was great. Now, by the time we got to here, got difficult to see that that would be continuing. Now, here it was very easy to see that earnings would be much better in the future because they’d come off so sharply. So at the extremes it’s always pretty obvious. But at any given point you can see it’s not necessarily obvious which way things are going to go, which is why that time frame matters, because the blues balance each other out over time. So that’s why our, that’s why having that time, regardless of our risk tolerance, is actually really important in markets. ‘Cause again, markets don’t care about your tolerance, they care about where they are relative to value. Okay, so you can see here that, yeah, earnings increasing, you’ve got earnings increasing or decreasing, dividends are actually quite consistent sort of all the way along. And here’s another way to basically show the same thing. So this blue line is rolling 12 month returns, you can see minus 30 up to sort of 60 plus percent is the sort of range you can get in the really short term. Okay. This is your odds accumulation. So this is dividends plus. Here’s your rolling 20 year returns. Right, because they’re now a reflection of the earnings growth essentially, right? So again, looking at it similar to our different ways. And here’s probably the best way I think to sort of understand how that volatility actually plays out. So here is, this is again the ASX 300, capital income over 20 years. Again, this is ’98 to 2018, so reasonable period of time. Went through the tech rack and some of these I talked about earlier. Here’s your capital return. So your average capital return during that period was about 4.5%. Think of that as how much the share price went up, on average. Your income was about 4.3. So in other words, you got an 8.8% return on average over that 20 year period from the ASX 300. And here’s our standard deviation. So as you recall from earlier, so two times standard deviation gives about 68%, and four times, so two either side, gives about 95. So what we know from this is 95% of our returns, so not only does our standard deviation of capital vary from 12, vary 12.6% per annum, But a standard deviation only varied one. In other words, 95% of the time, your capital return was between minus 21 and plus 30, which is a reflection of that graph we just saw, right? But your standard income, 95% of the time, your dividends were either 2.3 or 6.3, somewhere in that range. Hence, we saw that from, there is no dividend crash. So again, if I’m looking for stability of cash flow in the long term that grows, then this is exactly what I want, quite stable and quite predictable. I’m gonna have to put up with some short, some volatility to get there. So what does that look like, the investment return? So how does it play out actually? Let’s look at a couple of quick examples in practice. This is quite a good one. This is, you don’t have to worry too much. You can Google what this is, but this is essentially like a Japanese, Chinese, I think it is. It’s a high-end liquor, a bit like a high-end vodka or spirit, just sort of spirit. And the reason why this is a really interesting product not just because it’s got a really long history, but what this product is used for varies quite a bit over time. So it’s the sort of product that very wealthy families celebrate with. Think of it as the drink of choice. So you go to a high-end Chinese wedding, there’ll be a bottle on every table. And during periods, let’s just say periods of irrational exuberance, the price of this particular spirit can be quite extreme. But the company that makes it always wholesales at the same price. So it’s always wholesale at the same price. But what it sells for varies by an order of magnitude of beyond 10 times. Sometimes you can be paying thousands of dollars a bottle, sometimes you can be paying hundreds of dollars a bottle, right? Or even tens of dollars a bottle. So the company that owns it, this is their consensus earnings in the blue, what the market thinks the earnings are going to be, and this is their actual earnings year after year after year. So this looks, and not surprising, they make a fairly fixed amount of product, they sell it at the same price, right, and therefore it’s quite a predictable earnings multiple. Okay, here’s their actual share price. So back in 2021 over 2000, now down to well nearly a third off. So since December 2021 you’ve got a long history of very consistent solid earnings growth in a highly oversubscribed product that sells for a relatively fixed price, okay, yet the share price can be down 30 percent over a, what’s that, three year period. And look at the volatility you’re getting along the way. Now this is very similar to the volatility retail price depending on where who’s buying it and where. Here you know it’s been you know it’s on all those tables in a wedding right here not so much. Does that make sense? But the wholesaler the person making the product and therefore the investment itself this is their earnings but this is their share price this isn’t the share price of the retailer selling it this is a retailer of the company making it. So a rational investor would look at that and say well I wanna own this, look at my earnings growth, fantastic. But here’s what’s happened to your share price. Earnings up 68%, share price down 31. – Yeah, doesn’t seem to go together. – Doesn’t seem to go together. And that’s again why the market doesn’t care about your feelings, right? You have to buy yourself that time, because if you’re forced to sell this during this period, you are absolutely doing your dough in what is an otherwise really solid investment, there’s no way you’d be wanting to have to sell it. Does that make sense? You think, okay, well, that’s fine. That’s alcohol and it’s Asian alcohol. So maybe there’s volatility in Asian markets and there’s all these other sorts of things. What about something that’s a bit more obvious and stable? Okay, so this is my favourite. We’ve been through this one before, but I’ll go through it ’cause it’s so good. So this is the M2 back in the day when it was half owned by a company called Hills Motorway and half owned by a conglomeration of people like AMP. Okay, so M2 when it first came out, toll road in Sydney. This is expenses, right, the blue line. This red line is its earnings, right? Okay, so revenues going up nicely, very nice, solid compound annual growth, very fixed, it’s a road, right? So it’s really just depreciation, expenses are quite low. Here’s its return profile over that period of time from the Hills Motorway side. This is, think of this, this is a side that’s listed on the stock market. The other side’s not listed. It’s owned by A&P and a bunch of other funds, right? So they’re looking at this and saying, well, if I look at it from a valuation perspective, that value is continuing to go up in a reasonably steady way, in the same way that say residential real estate can look like it’s doing that, okay? Because this is just a toll road. You can see here my average annual return along the way though, Well, here, one year it’s well over 150%. These years it’s sort of like minus 30 odd, right? And everything in between, all right? So between ’95 and 2005, ’cause it was delisted 2005, its compound annual return was 27%, right? Which kind of makes a bit of sense when you see that earnings profile, right? But look at the volatility. Annualized volatility was over 30. This is in a toll road. All it does is clip tickets as people drive their cars through. And the volume of traffic clearly only goes up and/or the price goes up over time in a reasonably predictable way. So I can understand maybe an alcohol wholesaler, didn’t seem to make a lot of sense, but maybe you could argue that, well, it’s a business, there’s a lot of things that could go wrong with that, particularly in China. But this is a toll road in Sydney. And during that period of time, you’re getting unitised small parcels now are traded like commodities. So this is nothing to do with what’s the earnings prospect of M2, it’s all about trading at the margins, okay? And as a result of that, even with this steady predictable growth in income, trading gives you this effect of massive swings in price volatility. So again, it doesn’t matter how you feel this should go, the market can make it behave in very, very extreme ways because of the liquidity impact. Something that’s really divisible, can own lots of small units of it, that’s highly liquid, you can buy and sell it on the market in very small quantities, means it becomes, that thing becomes commoditised in itself, quite separate from the thing that it represents underlying. Does that make sense? Okay, so that’s a really important consideration when it comes down to how we construct portfolios, right? So again, what are we trying to do? We’re trying to make sure that anything that looks like a great long-term investment, like the sorts of examples I just gave you, it has to sit up here, right? Because it’ll give us that long-term return, but we have to buffer that with these other pools, right? Because that’s what buys us the time to be able to allow that compression of returns sort of over time. Does that make sense? So yes, the risk profiling, how much of this do you understand and what journey do you wanna go on? ‘Cause again, two things I’ve learned is, what is your timeframe, regardless of how aggressive you might like to be, if your timeframe is not long enough, then it’s really risky for you to be putting your money into Hills Motorway, which seems like the safest thing in the world because look how volatile it can be ’cause you’re on the listed side, not the unlisted side. Does that make sense? So the AMPs of this world, they were just taking the money every year and saying, “Thanks for coming.” Right? they didn’t have to suffer the return volatility of that ’cause they own the underlying assets, they just got a value to go out and say, what’s that earnings profile like? What’s an appropriate yield? In a similar way that you might value a commercial property. But you take the other half of it that’s now listed on the stock market, and one year your returns 160%, and the year it’s minus 40. Exactly the same asset, right? So the same risk of the asset, but a different risk meaning because of that liquidity scenario, yeah? So they’re the two things we overlay. So you asked that question of what do you do with a person who can’t handle that volatility in terms of price? Well, that’s how we move into this more conservative end, not because that suits the goal, but if the goal in the short term at least is to manage the behavioural risk, then we sacrifice that return to do so. Does that make sense? ‘Cause we’re better off getting a lower average return that continues to compound because the behavioural risk doesn’t pull them out, then the alternative between you would have been great, except behavioural risk was the limiting factor. Does that make sense? So you can think of behavioural risk as the limiting factor as to how much growth assets people have, overlaid with the goal of how much liquidity and access to cash do we need. And the combination of those things ultimately then drives what a portfolio looks like. But the goal for everybody should ultimately be be driven by that growth and stable pool allocation because that’s going to optimise the goal and the time frame in each individual case. So even though in an ideal world we’d say look your circumstances as in you need ten thousand dollars a year should dictate the split between save, stable and growth, we still have to face the reality that sometimes it’s not going to be like that and I could freak out at every small market movement and we go okay well we’ll lean a bit more towards the conservative side of things. Yeah let’s give you more time so we use that example right so as a general rule we’ll use a more realistic let’s say you’ve got you’re retiring you’ve got a million bucks okay you want to live on uh 50 grand a year okay so five percent yield that’s reasonable that money will last forever properly invested. Okay, however, because of that, we’re going to have probably something like $50,000 in our save pool, okay, we’re going to probably have 100 to 150 in our preserve. Okay, so we’re only going to have about 800 actually invested in growth assets, I say only. Now the GFC hits and that 800 is now worth 400. So the other 200 is still 200, because it’s unstable, okay, but your million dollars has now hit 600. People who have not experienced that and don’t understand the fundamentals of that, going back to our earlier graph of how will that play out over time, if we go back to here, right, to have this impact in terms of portfolio at that particular point in time, if you don’t understand that the the result of this will be this. Okay, if you have the time for that to play out, and if you haven’t taken undue specific risk, you bought a bunch of the wrong things, right? Then this will play out and the time will be fine. Okay, and so, and we can look at that in detail in other videos, but if that played out that way, then that stable pool is more than sufficient access to stable cashflow to buy the time required for this to play out and for markets to balance. That’s exactly why it’s been designed, why we designed it, and we didn’t even design it, why we’ve stolen the idea from pension funds and endowment funds and we would have to have exactly that profile. That’s exactly how they manage those portfolios. We’re just replicating what we know works. That’s the whole point of having principles, okay? So we know that if you wanna draw that level and we construct the portfolio properly, you will not run out of money based on any conceivable historical preference. Now, does it mean that can’t ever happen in the future? You can never say never, but the probability of there’s some exception, didn’t happen to DFC, didn’t happen to TechRect, didn’t happen to Bondcraft, didn’t happen in all these other things in the past that we’ve experienced. Therefore, it’s highly unlikely, and again, it’s about probabilities. We’ve given ourselves that probability weighted return, okay, which is all we can hope to do. There’s no certainty, there’s only just, Can we talk the probabilities? But if our participation risk kicks in here, which is exactly when it’s most likely to kick in, right? I wanna wait until the market’s recovered, which is not what people say, but it’s essentially what they’re doing, okay? And then they come back in here. Well, that loss has been locked in now, okay? The market’s not going back to that level. You’re never gonna buy back into that price. You’ve lost that amount of future return. And that’s the impact on that Dow Bar study. That’s where that comes from. And that comes from people often, and it’s often not even these big ones, it’s often just deaths by a thousand cuts as opposed to the one big thing they got wrong. But in my experience, people who get that wrong will tend to keep getting it wrong. Whereas if they have the buffer there and have time to buy it and say, well, by the time I need to sell any shares, they’re going to be worth a lot more, so why would I sell them now? I can wait that out. That’s very different though, if you’ve taken a great degree of specific risk. I put all my money in one or two stocks, or it’s very heavily weighted to one particular sector and that sector is blown up because, you know, we’ve talked about that with say lithium as an example, right? Where if there’s an example where there’s one risk, one of those risks, remember the probability is, well, what if the world changed the way it does things? What if the world changes the way it makes batteries and doesn’t require much lithium anymore? Lithium is overwhelmingly used in batteries and the expectation is it will continue to be used levels in batteries, but it has a fundamental problem catches fire and burns uncontrollably. So if someone can come up with a battery that isn’t based predominantly on lithium, lithium could conceivably, we’re not saying it will, but could conceivably disappear as a heavily mined ore. As a result of that, lithium miners, many of them would go to zero or substantially lower than their current prices. And therefore that represents a risk you might not be willing to take as a specific risk because of that. Does that make sense? So buying the time’s the really important part of that and managing the behavioural risk to do so. And again, all that means is that your return expectation’s gonna drop. Okay, your average is gonna be lower, your money’s gonna compound, which means it’ll either now won’t last your lifetime, you’ll run out a bit earlier, or you’ll leave a slightly smaller estate. Okay, now, they’re your trade-offs, you can choose which of those you’d prefer. Does that make sense? But our job is to help people understand that and what those trade-offs are because we’ll still be here in 15 to 20 years time when they run out of money and we don’t wanna sit there and say, “Oh, it’s not our fault. “It’s your fault because you didn’t invest properly “when we didn’t tell you how to do that.” Does that make sense? So obviously there’s a short version of this in terms of risk profiling, but the reason I wanted to go through this is to go through that kind of deep dive and to give a proper detailed description of exactly why we end up with what we end up with, even though it can look like a, on almost sort of cookie cutter calculator kind of scenario, in the sense that it really does come down to how are investments themselves likely to behave from a specific, from a market, from a credit risk perspective, and what’s the impact in terms of timeframes, and why are we so relaxed about dividend and dividend growth when markets can be extremely volatile, and I think we’ve shown that it’s the prices that can be very volatile, it’s the earnings that are actually quite predictable, and ultimately if we can give that time, there’s a high degree of probability that we will get that goal of maximising our future purchasing power. So, that’s our approach to risk profiling and how we construct portfolios. – Very nice.