I’ve been in the business of advising wealthy families for forty years. (Actually, it’s been longer than that, but I’ve reached the age where everything gets rounded down.)
Over all those years, almost every family I’ve worked with has followed an investment strategy focused on the preservation of their capital, and it’s not hard to understand why. Most of these families spent generations building up their wealth, and the last thing they want is for that wealth to disappear over a few months in a bad market environment or via bad investment decisions.
Investing for capital preservation makes sense from a second perspective as well, because it focuses first and foremost on risk, and only secondly on return, a strategy used by almost all the world’s great investors.
From a third point of view, capital preservation investing coincides with what we know about behavioral finance, i.e., it seems to be embedded in the human condition to hate losses more than we like gains.
Finally, capital preservation works mathematically: losses are far more harmful to capital than gains are helpful. Consider a $100 portfolio that loses 50% in year 1 and then gains 50% in year 2. It’s still down 25%. And it works the other way around, in case you were wondering: a $100 portfolio that gains 50% in year 1 and then loses 50% in year 2 is also down 25%.
Nor is it only the multibillionaires and centimillionaires who should be investing for capital preservation. I’ve also worked with roughly 300 middle income investors over the years, and the most sensible of them also focus on preservation of capital. Imagine a family that has been scrimping and saving for their kid’s college education. The kid is now about to turn eighteen, and the last thing they want is for those savings to disappear over a few months in a bad market environment or via bad investment decisions.
Indeed, even young investors, who can and should be taking more risk with their capital, should avoid taking on too much risk. For these investors the problem is almost purely behavioral. Very risky portfolios get hurt badly in Bear Markets, and this causes young and inexperienced investors to – as they might put it – freak out, sell everything, go to cash, and miss the market recovery.
Then, just as the next market cycle is peaking, the young investors, recognizing that they’ve missed out, buy back in. Almost immediately the market collapses and the whole cycle starts all over again. This herky-jerky, buy-and-sell-at-all-the-wrong-times behavior has had awful consequences. Over the twenty years ending in 2015, stocks produced 8.2% and bonds produced 5.3%. Investors, however, got 2.1%. (Thanks to BlackRock for these numbers.)
There are really only two problems with capital preservation investing. The first is that it’s hard to do. Capital preservation is hard because it requires that portfolios be extremely broadly diversified. In other words, simply investing in cash and a few bonds will preserve your capital in the absolute sense, but inflation will eat you alive. To take an extreme case, if you were the steward for a wealthy family and you put $100 million under a mattress for 50 years, even if inflation was only 3% you would be handing the next generation only a bit more than $20 million. If inflation moved up to a more normal 5%, you would be turning over about $8 million. Hire a good lawyer.
No, investing for capital preservation means paying attention to risk but still outperforming inflation. And that means investing in a lot of asset categories that are obscure, difficult to understand, and sometimes flat-out terrifying. (Forget buying only “what you know.” If all investors did that, the only thing they could buy would be hot dogs.) Almost every family that wants to follow a capital preservation strategy will need to hire a good advisor. I will modestly not mention any names.
But let’s turn to the second problem with investing for capital preservation, because it’s the topic of this series of posts: capital preservation investing is infuriating.
Defined very broadly, capital preservation means a willingness to give up something on the upside in order to preserve value on the downside. In other words, capital preservation investors expect to lag strong markets, but that’s okay because under those conditions their absolute returns are still quite good.
Unfortunately, those returns might be nicely positive, but they don’t look so good against the performance of people who ignore risk and just focus on return. And since equity markets tend to go up almost three times as often as they go down, this means that quarter-after-quarter, year-after-year, supposedly sensible capital preservation investors are being beaten by supposedly foolhardy, return-chasing investors. In other words, quarterly meetings with sensible investors aren’t always a barrel of laughs.
True, in bad markets, while everyone else is getting killed, capital preservation investors are getting less killed. That is to say, these investors don’t actually make money in a Bear Market, it’s just that they lose less than the more aggressive investors who beat them during the Bull Market. But, still, the sensible investors are losing money, and very often even at the bottom of a Bear Market they are still behind many return-chasing investors. Why? Because those investors have panicked and sold out before the bottom, while capital preservation investors are still invested.
So why, we might ask, would anyone want to be a capital preservation investor? That is, why would anyone want to pay good money for an advisor, then lose out on the way up and often lose out on the way down, too?
To find out, I’m going to launch a contest, an investor version of March Madness and that will be far more exciting – and bracket-busting – than that silly hoop version. I’ll ask Mr. Market to establish the parameters for the competition, and to make the contest fair and meaningful, we’ll ask Mr. Market to deliver a full market cycle of returns. By “full market cycle” I mean a series of market ups and downs that allows investors to navigate through all the usual behavior issues we face when we invest our capital.
Once we have the playing field established, we’ll turn to our exciting investment contest and observe how the various kinds of investors I’ve encountered over the years fare. Stay tuned.
Next up: Capital Preservation Paul, Part 2
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.