Different investment professionals have different opinions or philosophies on how markets work and, as such, how people should invest. At Cambridge Partners, we have an evidence-based philosophy.
Understanding Evidence-Based Investment
Evidence-based investing means exactly what it sounds like – every investment recommendation must be supported by empirical evidence. Rather than making decisions based on market predictions or gut feelings, we rely on proven strategies like diversification and targeting assets that have the risk and return characteristics a client needs. This approach allows us to create optimised portfolios that deliver the highest expected return for the lowest volatility. Most importantly, it ensures that a client’s investments are suitable for them, their objectives, and their situation.
The empirical evidence provides a clear picture of how to construct these investment portfolios. We need to diversify globally (as New Zealand is only a tiny part of the world’s capital markets and is susceptible to its own regional risks). We need to diversify across industries to manage industry-specific risks. Different countries, industries, and investment types have different return and volatility characteristics that must be considered alongside each client’s overall risk and return requirements. Also, some clever and academically proven factors can be incorporated into investment portfolio creation to achieve higher risk-adjusted returns.
The Reality of Risk Assessment
When working with clients, we conduct detailed assessments that consider both current circumstances and future goals. This process involves a deep dive into their financial situation, including current income, desired retirement lifestyle, and long-term objectives. We look at factors like their current asset base, savings potential, and the gap between their current earnings and future needs. For instance, if a client earning $200,000 annually needs $150,000 each year for spending in retirement, we calculate how much they need to save, so their pool of investment assets is large enough that they will be able to meet their spending objectives when they stop working.
But it’s not just about the numbers. We must also understand their estate objectives, charitable giving plans, and lifestyle expectations. Do they want to leave money to their children? If so, how much? Are there charitable causes they’re passionate about supporting? These factors all play into creating a comprehensive financial picture and determining the appropriate investment strategy.
Capacity vs Desire: The Critical Conversation
Here’s where things get interesting. Sometimes, a client’s required return doesn’t match their risk capacity. Consider an elderly client with $500,000 in savings who relies on their portfolio for rent payments. While they might want aggressive growth so they will have an estate to leave to their children, their capacity to weather market downturns is limited as they need to keep drawing on their savings regularly to meet their rental payments. These situations require honest and frank conversations about adjusting expectations or changing their circumstances (e.g., moving to a smaller/ cheaper house).
These conversations about lifestyle changes or spending adjustments can be challenging, but that’s better than advising clients to invest in a higher-risk solution they don’t have the capacity to cope with.
The investment world often seems complex, but the principles of sound portfolio construction remain straightforward: understand your needs, assess your risk capacity, and build a portfolio that aligns with both to ensure you can meet your objectives.