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It's all in the Mind

All investors consider risk before reaching for their chequebooks. But how accurate is their assessment? And doesn't perception of risk play a greater role in their decision-making than actual risk, asks Invesco's Ray Maxwell.

There is an urban myth that investors are sound and rational in their decision-making and that they use all available information to form a considered view, backed by sound judgment. They fully appraise risks and rewards, and in the fullness of time, they achieve successful outcomes.

If only this was so, everyone would be a winner. But, as we all know, life just isn't like that.

If we go back a few years, when the technology markets were raging, it felt as if the rules of the ‘zero sum game' were no longer applicable and all investment decisions, no matter how far-fetched, would result in positive outcomes. The tendency was to focus exclusively on reward and not on risk.

We do not exist in a risk-free environment. Being able to understand and manage risk is a critical feature of the human condition. Peter Bernstein observed in his book Against the Gods: ‘The essence of risk management lies in maximising the areas where we have some control over the outcome while minimising the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.'

Peter Bernstein's comments ring true. But I believe that perception of risk is of equal or greater significance than risk itself. We know that crossing the road can be dangerous and that smoking cigarettes can be lethal. Yet individuals do both, possibly at the same time. Society appears to be able to assess and to cope with these risks. On the other hand, it is intuitive that the risk of contracting SARS or CJD is highly remote but media hype created the perception that we were all potential victims. The perception of the risks associated with SARS did have unforeseen consequences as evidenced by the drop in tourist numbers in Toronto.

In the more narrow confines of private equity the perception of risk is a fundamental driver of decisions. As we've seen, technology enjoyed unparalleled growth during the mid to late 1990s. As entry prices rose precipitously, investors threw ever more money at an assortment of internet, telecommunications and chip deals based on the ‘greater fool theory'. Looking back at that period, it appeared that the potential for generating astronomic rates of return, no matter the valuation at entry, outweighed any fundamental analysis of risk. Investors clearly failed to heed either of Peter Bernstein's two precepts. Many investors acquired minority equity stakes with only cursory protections and were caught totally cold when the markets tumbled. Partnerships that had fully committed their funds had no reserves to continue to finance their portfolio companies and exits became illusory.

The question is, why did this happen? The glib answer is that no one could predict when the markets were going to collapse. But there were a number of strong indicators at the time that pointed to a reversal of fortunes. They were as follows:

• The stock markets' seven-year rise had to lose momentum at some point
• The yields on stocks were diminishing
• Most new issues, after lock up, traded below the IPO price because the price was set too high to give new investors a reasonable return
• The IPO was seen as an exit route for investors rather than a fundraising exercise for the company
• Corporate profits were beginning to come under pressure
• 3G licences were acquired at exorbitant prices
• The debt mountain in telecommunication companies could not be serviced
• Retail investors were piling into the market - a sure sign that the end was nigh
• Institutional investors were throwing money into venture capital, based on unrealistic return expectations.
• Too many ‘me-too' deals were seeking finance

The reason that little or no attention was paid to these indicators was that investors' psychology assumed that stock markets were going to continue to rise even though history demonstrated that markets behaved in a cyclical fashion. The risk that stock markets would fall out of bed was not contemplated and if it was at the back of some venture capitalists' minds, the hope was that they could sell out before the storm struck.

The paradox is that the climate for venture investment today is much more attractive than it was several years ago. Yet investors are shying away from this segment of the private equity spectrum and focusing on buy-outs. The reason is that investors still hold to the view that venture capital is risky and, given that many are sitting on losses, it is hard to disagree. However, a more reasoned assessment would suggest otherwise. Western economies are technology-based and there will be an increasing need to enhance systems, networks and products. For example, European telecommunication companies are expected to generate $47bn of cash this year, compared to outflows of $71bn in 2000, according to the Wall Street Journal (21 July 2003). Some of this cash mountain will be used to make acquisitions. Moreover, venture capitalists can be more selective in terms of the opportunities that they pursue and valuations are back to early 1990s levels. Although the appetite for new issues appears bleak over the near term, it is probable that the market will become more receptive in time as the bulls replace the bears.

At this point in the cycle the actual risks associated with investing in venture capital are relatively benign. However, investors still perceive that the risks are high and a significant percentage of the private equity allocation has been earmarked for buy-outs on the basis that the perceived risks are lower. Historically the European buy-out market has performed well, but the risk profile is changing as a result of slower economic growth (GDP growth of only 0.6% in the Euro zone), low levels of inflation, tighter debt markets, relatively low levels of M&A and no change in stock market multiples. An additional risk lies in the structure of large buy-out funds in that there is no incentive to assume risk to generate high multiples. Low risk investments will generate reasonable levels of carried interest and the primary source of GP returns is in the management fee.

There is little doubt that psychology plays a huge part in decision-making and that risk assessment is complex but it's clear that even the most sophisticated decision-makers are pulled along by momentum. The contrarian is often a lone voice. But there is nothing wrong in being 'far from the madding crowd'.

Ray Maxwell is managing director, private equity, INVESCO Asset Management.

Copyright © 2003 INVESCO Asset Management