Newsletter April 3, 2007 Investment Newsletter April 3, 2007

A focus on Preservation of Capital could cost you a bundle

Many financial advisors claim that you should focus on preservation of capital. This is usually defined as avoiding any major dips in your investment account. For example somehow insulating yourself against dips of greater than 5%. This sounds very logical. No one wants to lose money, even in the short term. This preservation of capital advice often appeals to anyone who is aware of the large losses suffered by many investors in the early 2000’s.

But too much focus on avoiding short-term dips could prove extremely costly and even cause you to miss the opportunity to accumulate a truly significant amount of wealth.

Most investors are investing for the long-term. Many are saving for a retirement that will only begin some years in the future, perhaps even 20 years or more in the future. Many retirees need the money to last some 10 to 40 years. Some retirees are also thinking about leaving money to children or grandchildren and this money also has a long-term focus.

So let’s think about how preservation of capital might apply to a long-term investor.

It is a fact that stocks have outperformed bonds in virtually every 30-year period (based on U.S. data). There is general agreement that this pattern is highly likely to continue. However stocks will exhibit dips of more than 5% on a very regular basis, more than 10% frequently and more than 35% occasionally.

It then becomes a mathematical fact that a focus on avoiding the short-term dips associated with stocks (Preserving Capital) is highly likely to cost you dearly in the long-run. Over a lifetime it could easily cost a middle class investor well over $1 million in foregone wealth.

Investment Advisors may have an incentive to steer you toward lower risk but lower return strategies. After all, when you experience a big dip in your account (as you definitely will with a high allocation to stocks) you are likely to complain bitterly that your Advisor should have pulled you out of stocks. You are likely to forget all the growth that stocks gave you. You may very well transfer your investment account to a different advisor. So basically if your Advisor suggests a heavy allocation to stocks, you will likely be much better off over a lifetime but when you run into dips your Advisor will take the heat. The Advisor therefore has incentive to suggest a lower risk approach.

A better approach is to focus on avoiding Permanent Loss of Capital. Invest in stocks that may be volatile but avoid stocks that have much risk of declining and never recovering. Most companies that have a good profit history and little or no debt have little chance of causing a permanent loss of capital.

Real Assets versus Financial Assets

In recent years many commentators and self-proclaimed experts have suggested that you should focus on investing in “real” or “hard” assets as opposed to mere “financial” assets.

Houses, buildings, land and commodities are often considered to be real or hard assets while stocks and bonds are considered to be financial assets. Indeed hard assets have been good investments in recent years.

I don’t agree that there is any great distinction between hard and financial assets. All investments are ultimately financial in nature. If you buy a 10-unit rental building, you cannot live in all 10 units and ultimately you will want this hard asset to provide you with financial benefits. Also it is difficult to understand that there is any great fundamental difference between owning stock in a company that owns apartment buildings, versus owning apartment buildings directly.

In extreme cases hard asset proponents may be trying to get you to invest in some very dubious thing like a gold mine that is not yet producing. If the sales pitch includes references to the fact that gold is real while money is just paper not backed by gold, I suggest you run quickly away from such schemes.

Our paper money system has been the grease that keeps our world economy growing and has led to the undeniably increasingly wealthy and more comfortable existence that most of the world’s population enjoys. Does anyone really think that at our paper money system is going to collapse and that they are going to be then buying their groceries with flakes of gold? I suspect that if paper money collapses, so will the economy and then there would be no functioning grocery store. A weakening currency should lead to inflation and hyper inflation. The low inflation of the past 25 years should provide comfort that there is no sign of any collapse of our paper money.

If any hard asset investment is a good one, it will be sold on its own merits. More dubious hard asset investments may stoop to fear-mongering regarding our financial system. These investments are to be avoided.

How Will Your Investments Grow over the Years if invested partly in Stocks?

Many financial advisors have software that they claim can “Show you” how your investments might do over a period of time, both in the accumulation phase and in the retirement phase. The software will typically show different graphs and possibilities based on your asset allocation and based on assumptions about returns, inflation and deposits into the accounts and withdrawals from the account. Some software will use “monte-carlo” simulations to show you a broad range of possibilities.

These software packages are helpful to gain some understanding of the possibilities.

In the end though, the fact is that no one knows how your stock and bond investments will grow or shrink either in the accumulation phase or in the retirement draw-down phase.

Even over 30 year holding periods the real (after inflation) returns on stocks has varied over a great range from about 4%, all the way to about 10%. Even balanced portfolios have had real returns that varied from about 3% to about 6% over different 30-year periods. See our graphs demonstrating this. It is difficult to plan for retirement needs when returns have varied over such a range.

My conclusion is that it is unrealistic to expect to lay out a precise plan for accumulating savings or even a plan for spending in retirement. In reality you will likely have to readjust the plan periodically depending on the returns achieved and your changing spending needs.

Does Asset Allocation Really Explain 90% of Your Portfolio’s Returns?

A false claim has been spreading around the investment community for years. It says that the individual stocks that you select don’t really matter much. It says that 90% of your return will be explained by your asset allocation (The proportion of funds in each of Stocks, Bonds and Cash). It says that only about 10% of your return will be affected by what particular stocks and bonds you select. It says that picking Stocks is therefore basically a waste of time.  The people saying this usually believe it. But it is at best a half-truth.

The origin of the false claim is a 1986 study by Brinson, Hood, and Beebower that found that asset allocation indeed did explain about 94% of the variability in pension fund returns. Technically variability is not quite the same as explaining return, but I don’t take issue that indeed asset allocation will indeed explain 90% or more of the difference in returns of pension funds.

The mistake occurs when people then jump to the conclusion that asset allocation explains 90% of the portfolio returns of most or all individual investors. This is obviously not true. We all know that stock investors who were concentrated in too may high-tech stocks during the early 2000’s suffered huge losses. Yet others with the same 100% allocation to stocks but who were widely diversified or invested in dividend paying stocks, suffered much smaller losses. In the extreme case if you invest all your money in 1 stock then it is certainly not going to be 90% correlated to the overall stock asset class.

Pension funds, almost by definition tend to broadly diversify across each asset class. If each pension fund broadly diversifies and has a portfolio similar to the index for each of stocks, bonds and cash, then of course its return is going to be driven by the percentage devoted to each asset class. But this in no way proves or even implies that the same applies to individuals. Individuals, especially those who Pick Stocks are under no obligation to have broadly diversified portfolios. Instead they often have portfolios that are extremely different than the market index. In this case their overall returns may be mostly driven by the particular stocks selected and not by their asset allocation. In this case, the particular individual Stocks selected would not have a 10% impact on the returns but instead cold have a huge impact.

For individuals who happen to invest in well diversified portfolios that closely match the index in each asset class, the 90% explained-by-asset-allocation will indeed be true. But to say that this rule applies to non-diversified portfolios may be well-intentioned, but it is false.


Shawn Allen
InvestorsFriend Inc.

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