This is not investing advice. Seek a financial professional before making important financial decisions. This article is for informational purposes and should not be interpreted as a recommendation to buy/sell/or trade any security.
What is your investing goal?
Everyone should have an investing goal, one that suits their particular situation. If you went to a run-of-the-mill investment advisor they might outline three common goals including capital appreciation, current income, and capital preservation. These terms are helpful, but we propose a new goal called "True Diversification".
In this letter we summarize the common financial goals, some criticisms.
Three Common Investing Goals
Let us first review these three common investing goals...
1. Capital Appreciation
Capital appreciation seeks long-term growth. In practice this typically means investing in stocks for many years and reinvesting the dividends. Capital appreciation accepts higher day-to-day price fluctuations in favor of achieving a higher overall return over a longer period of time. Younger investors, and those wealthy enough to absorb large losses, are commonly advised to take a capital appreciation approach.
2. Current Income
Current income seeks investments that pay out high cash flows. These typically include stocks that pay a consistent and high dividend, high quality real estate investment trusts (REITs), investment grade bonds. In practice, current income is thought to reduce risk by creating more predictable cash flow. This might be the case, but it might not. Consistency of historical cash flows does not guarantee safety...but it can create the illusion of safety. Investors living off their retirement savings are often inclined to pursue a current income approach because they may feel that it is easier to gauge the adequacy of their nest egg by whether the cash flows generated are sufficient to cover expenses.
3. Capital Preservation
Capital preservation seeks to avoid losses. In practice, this often means keeping money in the bank, CDs, Treasury Bills, and other assets that are believed to be very low risk. Investors that cannot afford to take a hit, such as the retired that would need to reduce spending if they lost wealth, are more inclined to take a capital preservation approach. They are seeking safety, acknowledging that this probably means giving up potential return. Whether they actually achieve safety depends a lot on the future path of inflation which can erode the purchasing power of savings.
The three goals above are useful for communicating, but we have a few criticisms. In short...these criticisms suggest to us that these terms are useful at indicating ones risk tolerance, but not so good at identifying a practical approach to achieving a particular risk level.
For example, suppose someone wants to “preserve capital” today. Interest rates on savings accounts and short term treasury bonds are near zero. Inflation has been very low for the past ten years, but if 20% of the workforce continues to get helicopter money without contributing to our means of production, there is a good chance we get much higher inflation.
How does one “preserve capital” when presumably “low risk” investments earn far less than inflation?
There is no good answer to this question. No portfolio can “preserve capital” in this environment (circa 2020) without taking on risk. We can accept negative real rates of return by keeping our money in short term CDs that earn less than inflation, but over time we will lose purchasing power.
What if our goal is to “Capital Appreciation”...does that mean we put nearly all our money in the stock market and ignore it for twenty years?
That appears to be what most money managers believe. Target retirement accounts with longer time horizons often cite “Capital Appreciation” as the goal...and these funds commonly have >80% exposure to stocks. But investors in Japan can attest to stocks losing over long periods. The Japanese stock market has not hit a new all-time-high in over 30 years!
One reason why investing in the S&P 500 is often considered the default investing strategy for young people is because it has been the best performing stock market in history, but that is some serious cherry picking. Many stock markets have collapsed since the first IPO. I’m not suggesting that the S&P 500 is going to collapse...my point is that how investors expect to appreciate their capital depends a lot on recent history.
In China for example, many investors believe that real estate is the best way to appreciate capital. Stocks are often shunned as “speculation” and the best way to increase “current income” is to start your own business. Why is it so different here? How will implementing these goals change if the housing market collapses and the stock market booms?
At least “capital appreciation” and “capital preservation” are clearly defined. The former wants to increase wealth, the latter seeks to avoid losses. What are “current income” investors trying to achieve?
I’ll explain with an example. Suppose you are invested in a stable “blue-chip” company called XYZ because it pays a consistent 3% dividend. Then XYZ temporarily suspends their dividend because they need the money to build a new factory in order to satisfy higher than expected demand.
Should a “current income” investor sell XYZ?
Technically yes...but for reasons that are clearly nonsensical. Without a dividend, XYZ provides no “income” but it’s now a more valuable company and so an investor can just as easily sell some shares to make up for the dividend cut. There is no logical reason why retired investors should prefer getting paid in dividends, coupons, or price appreciation. As Ford investors recently learned...historically consistent dividends create the illusion of safety, but not actual safety. Premiums for investments that produce higher cash flow tell us more about human psychology than they do about intrinsic value.
In conclusion...investing goals are helpful in communicating risk tolerance. However, practical implementation of these common investing goals can be tricky. Capital preservation implies a low risk tolerance, but investing in bonds is risky today and with sovereign bonds one is likely to slowly erode away one's wealth because of negative real rates. Capital appreciation is implies a higher risk tolerance, but it is not at all clear that this will be achieved by betting on whatever has done best historically like the S&P 500.
Our view is that no matter ones investing goal the core portfolio should be highly diversified across a wide range of asset classes and geographies so that performance is likely to be positive no matter the future state of the world. One can then simply increase their short term cash (or cash equivalent) position based on their risk tolerance. This is a concept we call True Diversification.
You can read about True Diversification here:
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