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Chapter 05: The Holy Grail—Capital Preservation and Growth

Chapter 5 image

“You can have capital preservation and growth at the same time!”

 

IF SOMEONE OFFERED YOU a “capital preservation and growth” strategy, would you take it? Sounds pretty good. Who doesn’t want all the benefit of equity-like upside growth with downside capital protection? Both at the same darn time!

And who doesn’t want to eat rib-eyes and ice cream sundaes every night but never gain weight?

The idea you can pursue capital preservation and growth at the same time as a unified goal is no different than the notion of a low-cal, fat-free, guilt-free rib-eye-and-sundae dinner. It’s a fairytale.

Capital Preservation Requires No Volatility …

First, let’s clear up common misperceptions about capital preservation. It’s a goal likely appropriate for fewer people than you think. And if you think it’s something you want (or need) long term, ask yourself why. True capital preservation means your portfolio’s absolute value should never fall.

And to do that—true capital preservation—you must eliminate most all volatility risk. (As discussed in Chapter 3, volatility isn’t the only risk investors must consider.) But if you eliminate volatility risk, you not only avoid the times stocks are down, you avoid the 72% of all years stocks are up! Effectively, you’re limited to cash or near-cash vehicles, which means likely seeing purchasing power eroded over time by inflation.

Sure, you could get better-than-cash returns by investing in Treasurys. But if you do that correctly, you’re giving up some flexibility. How so? Treasurys can and do experience price volatility and have had shorter periods of negative returns. (Again, see Chapter 3.) Which means if you sell a Treasury prior to maturity, you can sell at a loss. (Yes, that’s the opposite of a capital preservation strategy.) So to accomplish capital preservation via Treasurys, you likely must hold them to maturity.

But that’s still a strategy that may lag inflation. Inflation’s long-term average is 3%.1 As I write, the 10-year Treasury rate is 1.6%.2 The 30-year rate is 2.8%!3 If you lock up your funds for 30 years, you might just lag inflation. And if you don’t hold to maturity, again, you can sell at a loss. And with interest rates at historic lows, odds are they do rise in the long period ahead, diminishing the value of your bond portfolio.

That’s capital preservation—the absence of volatility risk. Which means true capital preservation is rarely appropriate for investors with long time horizons.

… But Growth Requires Volatility!

On the other hand, growth—even mild growth—requires some volatility risk. It’s the opposite of capital preservation. I can’t say it enough: Without downside volatility, there is no upside. And as shown in Chapter 1, upside volatility happens more often (72% of all years) and to a bigger degree, even if our brains don’t remember it that way.

Which means, as a unified goal, you simply cannot have capital preservation and growth at the same time. It would be a physical impossibility. You cannot have upside volatility with no downside volatility. If someone tells you otherwise, they’re lying to you. Maybe unintentionally, which is bad. Maybe intentionally, which is worse! The more growth appropriate for you, the more shorter-term volatility you should expect. No way around that. Accept that now, and your expectations won’t be out of whack. (Out-of-whack expectations can be very damaging indeed—see Chapter 17.)

And yes, steep shorter-term volatility can be difficult to experience—a reason many investors fall short of their long-term goals and in-and-out at all the wrong times.

Let me seemingly reverse myself for a moment. You can’t have capital preservation and growth as a single, combined goal. However, as a result of a long-term growth goal, you very likely will have preserved capital over the long term ahead.

As shown in Chapter 1, over 20-year rolling periods, stocks have never been negative (and they nearly always beat bonds by a wide margin). The past is never a guarantee of the future, but it does tell you if something is reasonable to expect. Human nature hasn’t changed enough and won’t change enough in your lifetime (or your children’s or their children’s or for many millennia) to diminish the power of profit motive. As such, it’s very likely stocks continue to net superior returns over very long periods ahead.

Which means it’s very likely, over the next 20 years, your well-diversified equity portfolio will have grown—maybe a lot. Maybe doubled two or three times or thereabouts. So you will have gotten growth and preserved your initial capital with volatility along the way.

Yes, you would have experienced shorter periods of negative returns. And yes, at points, your portfolio may have dropped below your starting value. But over longer periods, the odds are stacked heavily in your favor you will experience growth, which means you’ve also preserved capital. But that is all the result of having a growth goal. If you pursue capital preservation as a goal, after 20 years, you likely have your starting value and not much more.

Which means anyone selling you capital preservation and growth as a single, combined goal either doesn’t know much about finance theory or is trying to fool you. Either one is bad.


Notes

  1. Global Financial Data, Inc., as of 05/22/2012, annualized average of Consumer Price Index from 12/31/1925 to 12/31/2011.
  2. Bloomberg Finance, L.P., as of 10/25/2012.
  3. Ibid.

 

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