If you are the most powerful man on earth, then capital preservation is easy. The President of the United States keeps the US government’s gold in a fortified vault, surrounded by an army base! Sadly for us mere mortals, we do not have our own Fort Knox, but there are other ways we can preserve our capital.
The theory behind capital preservation
Differences in application
How to apply it to your portfolio
Capital preservation is a manner of investing by seeking to protect one’s capital from loss of value. Traditional loss of value is the decrease in the book value of your capital, such as selling a share at a 20% loss.
Preserving your capital can also be against less obvious forms of loss, such as inflation risk. The loss of purchasing power is a ‘stealth loss’, which although not immediately noticeable, will have an impact over time.
Finally there is the preserving of capital against systematic risk events, where your entire wealth loses value. If you are able to take steps to protect your capital from downside risk, then you may be able to profit from an economic downturn, as well as living your life stress-free.
Inflation risk, the loss in value of your stock portfolio and volatility are all different types of risks, which can reduce your capital, but there are others. The spectacular unraveling of the former star stock picker Neil Woodford is an example of liquidity risk.
Liquidity is akin to a fire exit: you reach safety quickly.
Although there were other problems, such as bad performance, the lack of liquidity meant than even when his fund folded, there were further painful losses for investors. This is because the market was alerted that his positions would be sold off and pushed these prices down.
Finally, counter party risk should not be ignored. Is the person or company you are investing your money with going to be able to pay it back? The extraordinary stimulus packages that central banks around the world have laid out, have created a situation where moral hazard has gone out of the window. Investors should not never rely on someone else to bail them out.
Ensuring that you plan to preserve your capital against the risks we have highlighted should be your first step. There is always the risk of the unknown. As a result it is worth diversifying your portfolio to cover off the different risks. Although at times some risks are lessened, they always come back eventually.
Risks reduce but never disappear.
It pays to invest in areas which are seen as presently unimportant. You can be sure that when the time comes, risks which were seen as unimportant to protect against will become expensive and over-valued.
Any contrarian investor should always be looking to get into an investment before others have. When the rest of the market awakens to a risk, you are already positioned to benefit, profiting in the process.
Discipline is another way of preserving your capital. Always giving yourself a margin of safety will ensure that if you get it wrong, the cost is not crippling. No-one ever gets it completely right, so maintaining some discipline at all times is critical.
Capital preservation can be applied differently depending on which country you are located. A country’s economic history can play a part. Many older UK residents will remember inflation at 15% in decades gone by.
As a result a typical portfolio run by a UK investment manager will have large allocation to equities. This is due to the ability of companies to pass on price rises, which reduces the damage caused by rampant inflation.
In Switzerland the approach is different. The conservation of capital with reduced volatility is seen as primordial. A portfolio run by a Swiss portfolio manager will have a smaller equity allocation and a much larger allocation to bonds. You will also regularly find a 5% holding in Gold. This is due to the belief that Gold is the ultimate store of value. Finally, it is obligatory that Nestle shares will also be included. Although national pride has a part to play, the quality of Nestle’s brands are also a strong reason to own its shares.
It is possible to invest your money yourself in a manner which preserves your capital. In particular there are two investment trusts in the UK which focus on this. Ruffer Investment Company and Personal Assets Trust’s positioning relative to other funds is often different.
They are influenced by a desire to protect their capital from risks that others are ignoring. This is attractive for both diversification reasons but also because they have proven to hold up well in choppy markets.
For those looking to equities for capital preservation, then demanding an equity risk premium is mandatory. At times when others are following the trend, keeping an eye on the fundamental value of an investment will reduce the effect of a sell off.
With the inherent volatility risk when investing in equities, those seeking to sleep without worry will need to look beyond equities. Inflation-linked government bonds will protect your capital against inflation, whilst also having a reduced counter party risk.
There is no one solution to protecting your capital, but you can invest in such a way to ensure your capital is protected from various risks. At its core, you should always remember to grow your investments to meet future unforeseen liabilities such as Inflation!