Why focusing on risk can result in better wealth preservation
Painful losses from the financial crisis have led to a surge of interest in wealth preservation. Is it possible to strike a balance between generating sufficient growth and protecting invested capital? We have developed a portfolio solution that aims to achieve both goals.
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1” – Warren Buffett
Painful losses from the financial crisis have led to a surge of interest in wealth preservation. Investors, however, are reluctant or unable to turn their backs on additional return. Is it possible to strike an optimal balance between generating sufficient growth to meet current and future demands and protecting invested
capital? In this paper we try to develop a portfolio solution that achieves both goals.
Defining wealth preservation
Before considering traditional approaches to wealth preservation, we must define what it means to preserve wealth. Much will depend on the investor’s timescale. As that grows longer, investors should consider two things:
1. The impact of inflation. Inflation may be of little concern over very short horizons, but it will matter much more over longer horizons.
2. The opportunity cost. As the investment horizon grows, so does the opportunity cost of not investing the capital more productively than simply to preserve its value.
These considerations should help shape our definition of wealth preservation, which we think should include four components:
1. An investment time horizon of at least five years
2. Compensation for the longer investment horizon
3. Preservation of purchasing power
4. Consistency of returns to accommodate moderate capital withdrawals.
So how have traditional approaches to preserving wealth fared when measured against these criteria?
The failings of individual asset classes
Money market and bond investments: Taking the very long view, a dollar invested in Treasury bills at the beginning of 1948 preserved real wealth over the following two generations, but had grown to only $1.60 by the end of 2014, after adjusting for inflation1.
For 10-year Treasuries, the gain (at least since 1953) has been much healthier – to over $4 – but there were long periods when purchasing power was not preserved for either asset class. Indeed, from 1953 to the early 1980s, purchasing power often fell considerably: over that entire period, there were no gains after inflation2.
Index-linked bonds, gold and commodities: For the 12 years of data we have for Treasury Inflation-Protected Securities, the investor’s dollar has become $1.20 in real terms3. Even then, returns have been volatile, with yields since 2008 falling below inflation. Gold has fared better – with a dollar rising to nearly $5 between 1968 and 2014, after inflation4 – but it has been a roller coaster ride. Our inflation-adjusted dollar had grown to $8 in 1979 but was back close to par in the early noughties. Meanwhile, a basket of commodities put together in 1991 has since cut our dollar’s worth to just under $0.755, in real terms.
Equities: Investing in shares has, of course, been a much more potent preserver of purchasing power, turning a dollar in 1950 into nearly 11 inflation-adjusted dollars by 2014. It hardly needs saying, however, that the investor has needed strong nerves. For instance, the peak reached in the late 1960s was not recovered until the early 1990s. And it is only lately that the all-time high attained in 2000 was regained in real terms6. Stocks may be sensible for the very long run, but they lack the stability required to preserve wealth.
1 Cumulative returns after deducting monthly inflation as measured by the seasonally adjusted US Consumer Price Index. Source: Three-month Treasury bill yields, Federal Reserve Bank of St Louis, January 1948 to May 2014.
2 Ten-year constant maturity yield, Federal Reserve Bank of St. Louis, May 1953 to January 1976; Bank of America Merrill Lynch 7–10 Year Total Return Index, February 1976 to May 2014, inflation adjusted as per footnote 1.
3 Barclays US Govt Infl-Linked Bond 0–5 Yrs Tot Ret Index, October 2002 to May 2014, inflation- djusted as per footnote 1.
4 London 3 pm gold fixing price, Federal Reserve Bank of St. Louis, May 1968 to May 2014, inflation-adjusted as per footnote 1.
5 Bloomberg Commodity Index and Yahoo Finance, February 1991 to May 2014, inflation-adjusted as per footnote 1.
6 S&P 500 Total Return Index, inflation-adjusted as per footnote 1.