What is capital preservation? Why avoiding capital loss is the most important criteria to achieve financial freedom?
There are some people who are extremely successful in managing their finances. While there are others who struggle to build wealth though they earn a lot. If we look at some of the most successful investors, we tend to think that they invested at the right time; they were lucky to make a lot of money. But a common trait among these investors is capital preservation. Not just investors, even some smart individuals save money without losing a single penny.. These individuals become financially stable very early either in their late 30s or early 40s.
Let’s take an example and see what a capital preservation focused investing strategy does to your wealth. Rachel is an extremely conservative individual. She is not a believer of becoming rich overnight. She wants to work continuously till 50 and she saves whatever is left after spending for her day to day expenses. She doesn’t want to lose any of her savings. Hence, she is risk averse and she parks her savings in risk free investments like fixed deposits, Government bonds etc. Her money grows at 7.5% every year without any deviation. At this rate, she is likely to double her investment in 10 years. (A 100 invested becomes 200).
On the other end, you have Peter who is enterprising in nature. In terms of saving his hard earned capital, he is interested in getting high returns. But he is not extremely focused on capital preservation. He doesn’t even think about what would happen if his returns are negative? He invests his capital directly in stocks. And he expects a return of 12% every year (CAGR). At this rate, his initial investment of 100 will become 200 in just 6 years. He finds this exciting.
During year 1, Peter’s investment grows at 12%. His initial investment of 100 is now worth 112. It is greater than Rachel’s portfolio which is now just 107.5. Peter is happy with his decision of investing in risky assets. Then year 2 gets over. Peter’s savings once again grows at 12%. He is super excited as his portfolio is now worth 125 whereas Rachel’s investment is now worth only 116. He starts to believe that risky assets will continue to provide great returns every year and he will double his savings in just 6 years. By this way, he is confident that he could become rich at a young age and achieve financial independence. Unfortunately, year 3 was not a great year for equity investments as most of the stocks crashed due to an economic downturn. Peter’s portfolio went down by 12% and ended at 110 while Rachel’s portfolio continued to provide steady returns of 7.5% and moved to 124. Now Peter starts wondering whether he made the right decision.
Another year goes and economy is yet to recover from the slowdown. Hence, Peter’s portfolio continues to struggle. His portfolio suffers another 12% loss. After year 4, his portfolio value is 97, which is lesser than his initial investment of 100. Even in year 5, Peter’s portfolio delivers a negative return of 12%. His initial investment of 100 is now worth just 85. Peter didn’t give attention to capital protection. Hence, his portfolio value has come down drastically. After year 5, even if his portfolio grows at 12% every year, it will take 13 years to double his money. Whereas, Rachel’s investment doubles in ten years without any undue pressure on her.
Had Peter focused on capital preservation, he might have invested some of his capital in risk free assets. Investing all your savings in risky assets is not a wise strategy to build wealth, especially, if you are not fully aware of your investment risks. And you should do proper due diligence to ensure that you will not encounter permanent loss of capital. If you can avoid loss of capital, your money will compound magically and will help you to build wealth. Whereas, if you continue to ignore capital loss, you will continuously invest your savings in risky assets. You will never be able to build a portfolio of significant size and you will not be able to achieve financial independence.
Of course, you cannot conclude any article without mentioning Warren Buffett’s quote.
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