Many stock market investors enjoy tracking and reviewing their investment portfolios diligently; some even obsessively. They meticulously research new assets to add to their portfolio, remove those that are not delivering a decent return, rebalance the mix to align with changing market conditions, consider whether they want income or long-term capital growth, diversify sufficiently to have longevity whilst also maintaining an aspect of quality, and account for their risk tolerance at various stages of life. How many of us approach our businesses, life, and career decisions through the same portfolio lens? How might a professional investment manager approach the management of a farm?
Start with identifying your needs and objectives: There are a wide variety of reasons, motives and ambitions for running a farming business. None of these are incorrect. But building business decisions around well established and profoundly rooted life goals is more likely to contribute to greater success and fulfilment – ‘success’ in whatever sense you perceive it. Be specific about what you want to do, whether you want to earn a certain amount of income or you want to expand the capital of your farm for future generations. Make this your starting point and build from there.
Understand the risks and know your own personal risk profile: Risk management is a very significant aspect of stock market investment management because all investments carry varying degrees of risk. Bank deposits, for example, are often seen to be the least risky, although they can be affected by inflation. The business decisions you make on your farm will also carry varying degrees of risk. For example, some farmers may prefer a drought-resistant variety of crops to high yielding varieties that could fail in a drought. The important point is that you match the degree of risk to your own personal risk profile, no matter how you choose to invest. Investment managers see risk profiles as comprising of three elements – how much risk an individual psychologically prefers to take; how much risk an individual can afford to take; and how much risk an individual needs to take. Here are the steps for assessing your risk profile:
Step 1 – Risk tolerance: At Churchgates, we measure risk tolerance using a questionnaire developed by a company called FinaMetrica. This produces a score between 0 and 100 which is unique to each individual and guides our approach as to how much risk an individual can psychologically tolerate. You may not have access to such tools, but you can evaluate your emotional reaction to prior decisions and experiences to critically examine your risk attitude. Think about how you would feel if you lost maybe ten, twenty or even fifty percent of your income or invested capital. How much risk do you feel you can tolerate compared to others around you?
Step 2 – Risk capacity: Sometimes referred to as ‘capacity for loss’. An investment manager usually carries out an objective assessment of a client’s risk capacity. An individual with a high-risk capacity might have high excess income from other sources. A low-risk individual might not have enough income to cover basic living costs or low cash reserves. Think about the risk capacity of your farm, of you as an individual and that of your family. Your farm may be experiencing cashflow problems, but your family may have additional personal assets and income streams from outside of the farm. Keep your risk capacity evaluation, which is objective and financial, distinct from your risk tolerance evaluation, which is subjective and psychological. Try to keep the emotion you feel towards your herd of cows separate from the return you earn on them.
Step 4 – Risk required: When you have a defined investing goal or expected rate of return, there will be a risk required. This is the amount of risk you must accept to have a reasonable probability of accomplishing your goal. For example, if you wish to save £500,000 for retirement in five years but only have £400,000, you will need an average annual investment return of 4.56%. This level of expected rate of return will correlate to a level of required risk. Expected returns and risk have a positive correlation. If you want greater returns, you must be willing to take on more risk. On the other hand, if you have a low-risk capacity you might have to lower your expectations of your goals.
Step 4 – Determine your risk profile: It is improbable that your risk tolerance, risk capacity, and risk requirement will all be in sync. Your risk profile will be a compromise of all three elements, or you may determine that one aspect is more essential to follow than the others. In practise, this will entail you making decisions and making judgments about the degree of risk you want to accept.
Avoid market gossip. Due diligence is required since all investments are susceptible to market risk: Making business decisions based just on chatter is risky. What works for your neighbouring farmer may not work as well for you. An investment manager will consider and quantify the expected rates of return and the variability of returns on a wide variety of asset types. Always return to your purpose and risk profile while constructing a portfolio and strive to follow the goldilocks principle of taking just enough risk to fulfil your objectives.
Diversification is key: Diversification has long been regarded as a cornerstone of sound financial management. According to government estimates, 62% of UK farmers will need to diversify in order to provide a consistent income. Many farmers find that adding new activities to their farm and keeping a varied portfolio of activities gives them peace of mind that their farm will be able to weather multiple market cycles. Similar to how investing in government bonds may give stability to a stock market portfolio, having a furnished holiday let on your farm may give an alternative source of income when commodities prices are low and traditional agricultural operations are struggling. It is always up to you how diversified you become, but it is vital to understand the individual risks in your current portfolio and spread out wherever the right opportunity presents itself.
As the world evolves, periodically review how your farm is faring: Even the very best investment managers can get decisions made at the outset wrong and therefore regular reviews are required to assess whether the selected investments are still performing as expected. A competent investment manager will ensure the strategy and investments remain ‘suitable to meet the needs’ of the investor on an ongoing basis. Farms are exposed to changes in threats and opportunities which can make decisions made at the outset wrong or inefficient. For example, a decision made to specialise as a barley farm whilst barley prices are high could be a very successful, but that decision might not be so lucrative if barley prices decline. Without regular purposeful reviews, such changes in the economic environment might not be picked up until it is too late. We recommend making a twelve-monthly review of your farming business a habit.
Whatever manner you choose to think about and operate your farm, there are certain seemingly trivial but yet significant concepts to take away and consider from the world of investment management. These are: identify your objectives; analyse your risk profile; carry out due diligence; develop a diverse spread of activities; and review on a regular basis. A farmer who can properly comprehend and use these ideas will, hopefully, develop a resilient and high-performing farming portfolio.
