IT IS one of the many paradoxes of life that we tend to save more when times are bad, and less when times are good. The reasoning is simple; when times are good, it does not seem so important to save money, as we feel confident about the future. In the same way, when times are bad, we become more fearful, and want to cut our risk and act to save more. Times are bad right now, and so there is a new focus on risk reduction and capital preservation.
This simple fact of behavioural psychology should have a significant impact in the way that portfolios are constructed, and the strategies that individuals and managers employ to try to preserve capital. The first, hard part is to define “low risk”, as this is very dependent on individual circumstance. For example, if you are dependent on the income from a portfolio, you want strategies that provide a high certainty of income, and you are relatively indifferent to changes in capital value over the short term. However, you are very sensitive to changes in the capital value in the long term, as this will have a dramatic impact on the future ability to generate income.
The second part is to try to set up a strategy to cope with changes in the world around you, and changes in your personal situation, and this is where it is important to pay attention to psychology. The best way to reduce your risk in a portfolio is to find ways to make few changes, and to only trade driven by changes in your needs, not changes in the market prices of assets. In simple terms this means that you should “be fearful when others are greedy and greedy when others are fearful” (Warren Buffett).
The third consideration that should be central to any strategy that is aiming for capital preservation is to pay significant attention to reducing the cost of ownership over time. There are two things that are even more pernicious than incompetent investment advice, and they are the effect of taxes and the effect of recurring fees. When selecting any investment, you need to pay attention to the total expense ratio (TER), of the fund. This will be in the range of 0.50 per cent to 2.50 per cent, depending on the type of fund. If you think this through, that means that if you invest in a fund with a 0.50 per cent TER and hold it for a decade, you will have paid 5 per cent of your capital in fees to the fund provider. If, however, you have selected a fund with a 2.5 per cent TER, you will have spent 25 per cent of your initial capital in fees over the decade. Now, you would hope that the fund with the higher TER would have had better performance, but history (and statistics) tell us that there is no reliable relationship between the TER of a fund and its performance. High charges are a deadly drag on performance over the long term.
So capital preservation should start with the process of making sure that you are not investing in a structure that will be expensive to maintain.
How can an investor put this into practice? The first thing is to think through your objectives, and write them down. Once you have worked out where you are trying to get to, your target, you can look at the best way to get there. This has become a lot easier over the last few years, mainly as a result of the growth of exchange traded funds. If you focus hard on the TER of the funds that you buy, you will then have a robust, low risk way of preserving capital over the long term.
Last but not least you need to be prepared to lose money from time to time. No strategy that genuinely preserves capital over any but the shortest period works all the time, and the best way to stay rich is to be prepared to hold on in bad times.
Charles MacKinnon is chief investment officer of Thurleigh Investment Managers.