A few weeks ago, I had the privilege of listening to Professor John Kay, the renowned economist, author and regular contributor to the Financial Times, speaking at the annual Cazenove Charities investment lecture.
His talk followed two main themes: investment uncertainty and long-term decision-making in endowment asset management, with his thesis challenging the received wisdom and suggesting that "we make serious mistakes in describing risk in endowment management".
Kay is fortunate to have three different perspectives from which to draw experience as an influential academic, as someone involved in shaping public policy debates and as a fellow and long-term member of the investment committee at St John's College, Oxford. He believes that describing risk as volatility of capital value is bad for beneficiaries and for the economy. This mistaken conception has driven financial regulation and, therefore, the approaches of most providers of investment advice. In his view, many advisers are overly focused on short-term volatility, thereby skewing portfolios and investment decisions.
People make decisions based on what is important to them. Risk is not objective or a number that is the same for everyone, but it is subjective and personal, and should be defined as failing to meet your realistic objectives.
For endowments, the main investment risk is failing to achieve a sufficient return to meet the charitable purposes over the long term. For a saver, the risk might be that the money doesn't stretch to a deposit on a house. For a fund manager, the risk might be short-term underperformance curtailing their career. Different investors have different perceptions of risk, creating an opportunity to trade with each other to mitigate their own personal risk.
Many charity investors are looking for long-term returns above inflation - as a result, the key decision is how much to entrust to real assets, such as land or commodities. Safe assets such as cash and bonds are classified as low risk by their limited short-term volatility. Real assets are likely to be more risky, according to volatility. Real assets outperform safe assets over a single year about 60 per cent of the time. But extend this time horizon to 25 years and there is a 99 per cent probability of real asset outperformance.
It is also clear from history that significant periods of real asset underperformance come from unpredictable events. We can't know what the future will hold, and we can't be sure of the outcome, but the longer the time horizon the more likely we are to generate returns from real assets.
Kay gave six bits of advice for successful endowment asset management. They are: think of risk as it affects the endowment and the beneficiaries; concentrate in real assets; mind your portfolio risk - don't avoid risky investments, but build a diversified portfolio; think for the long term - although herd mentality creates correlation in the short term, endowments have the luxury of time, which provides opportunities; pay less and minimise intermediation - costs reduce returns; and don't pull the plant up every few years to see how it is growing - find a good manager and let them get on with it.
Kate Rogers is head of policy at Cazenove Charities