After a raging bull market, capital preservation is generally a good idea. After all, the last thing you want to do is give up all of your gains and then some. If you do, that would be like wasting a whole bunch of time and emotional capital.
Since I started investing in 1995, I've round-tripped many individual investments. As a result, most of my equity capital has been invested in passive index ETFs. You might get lucky buying a stock with great gains. But you've got to get lucky twice by knowing when to sell the stock as well.
For example, soon after I had bought Life Time Fitness Group, the stock zoomed up 40% within 30 days. Once the omicron news came out, the stock came all the way back down to my original purchase price. As the stock collapsed, all I could think about was what a waste of time it was researching and writing my article.
Let's discuss capital preservation and our desire to protect our money.
Capital Preservation Investments
If you want to protect your capital, here are the most obvious conservative investments:
- Hard cash
- Treasury bonds of all durations
- Certificate of Deposits – $250,000 FDIC-insured per depositor, per FDIC-insured bank, per ownership category
- Money market accounts – $250,000 FDIC-insured per depositor, per FDIC-insured bank, per ownership category
- U.S. savings bonds (Series EE and I Bonds)
For capital preservation with more risk and potentially more reward, you can also invest in the following:
- AAA-rated municipal bonds
- AAA-rated corporate bonds
- Gold and other precious metals
- Fine art and other rare collectibles
- Target-date funds
- Real estate
- Hedge funds
- Other active funds like leveraged buyout funds
I've got investments in all of the above capital preservation investments except for Series EE savings bonds and annuities.
Cryptocurrencies, unfortunately, are not capital preservation investments. When Russia invaded Ukraine, cryptocurrencies plummeted in value while gold rose in value.
Related reading: The Best Financial Moves To Grow Your Wealth
Capital Preservation Investments As A Percentage Of Net Worth
The more conservative you are, the greater the percentage your net worth consists of capital preservation investments and vice versa. At the minimum, everybody should have at least six months' worth of living expenses in cash or liquid securities in case of an emergency.
In terms of recommended capital preservation investments as a percentage of net worth, I've generally followed this net worth allocation guide I created. My steady-state Risk-Free allocation is 5% of net worth. Risk-free includes Cash, Treasury bonds, Certificate of Deposits, Money Market accounts, U.S. savings bonds, and AA-rated Municipal Bonds.
Corporate bonds, target-date funds, hedge funds, and real estate are clearly not risk-free. But they do help to preserve capital versus an all-equity portfolio during a downturn. If we are to include all of the capital preservation investments above, then an appropriate net worth percentage can easily range between 5% – 70%.
Excluding the value of my business, target-date funds for my children's 529 plans, and real estate, roughly 15% of my net worth is in capital preservation investments. I know that if all else fails, I'll have at least 15% of my net worth to live off.
I can either draw down principal to pay for living expenses. Or I can live off the roughly $45,000 in passive income my capital preservation investments produce.
Check out Fundrise, my favorite real estate investing platform if you want to earn more passive income without much volatility.
Disadvantages of Capital Preservation
The biggest disadvantage of using a capital preservation strategy is inflation. The higher the inflation, the less purchasing power your capital preservation investments have over time.
The interest rate paid by fixed-income investments is almost always a nominal interest rate. This means the rate doesn’t account for inflation. A fixed-income investment’s real interest rate is the nominal rate minus the rate of inflation. Therefore, if a municipal bond fund is yielding 3%, but inflation is 5%, the real municipal bond yield is -2%.
The more negative the real interest rate, the more your investment is losing value. As a result, in a high inflationary environment, it is usually better to have a lighter capital preservation strategy. Instead, it may be better to take on more debt to buy potentially appreciating assets.
Of course, there are no return guarantees. In a bear market, earning a negative real interest rate is much better than losing a tremendous amount of principal.
Why You May Want To Pursue Capital Preservation
We've already mentioned that pursuing capital preservation after a massive bull market may be desirable. The last thing we want to do is violate the first rule of financial independence: never lose money.
Here are some other reasons why you may want to shift more towards a capital preservation strategy:
1) Plan on buying a house.
A house is a large ticket item, which often requires a 20% down payment. Therefore, it's good to minimize risk on your down payment the closer you get to purchasing your house. If you're within six months from purchase, you should probably have the lowest-risk capital preservation strategy possible. Here's my framework on how you should invest your down payment.
2) Close to paying for college within five years.
College tuition is also, unfortunately, a large ticket item. The closer your child gets to attending college, the more conservative your investments should be that are earmarked towards tuition. During the 1997 Asian Financial Crisis, many international students from Thailand and Indonesia had to take a leave of absence because their currency got devalued and their stock markets got crushed.
3) Close to retirement.
If you're almost at the finish line, then adopting a greater capital preservation strategy makes sense. I know people who made millions on paper during the 2000 Dotcom bubble only to lose it all and then some.
One sandwich shop guy I knew planned to go back to Lebanon and retire. But since he lost all his money after the 2000 dotcom collapse, he ended up making sandwiches for at least seven more years. It's not worth taking on so much risk if you've already accumulated enough capital and passive income to live free.
4) A health issue that is chronic or growing.
Unlike in retirement, you might not be able to work if you have health problems. Therefore, you cannot afford to risk losing a lot of money because you might not have the ability to make up for your losses through active income.
Hopefully, you have insurance, a pension, passive income, and social security to cover you in case of a problem. The older I get, the more I appreciate life insurance. Life insurance was my #1 financial move to help decrease stress and anxiety during the pandemic.
Protect Your Gains After Great Runs
We've had a great run since 2009. We've also had a speculator run since the start of the pandemic in 2020. To give up a lot of our gains would be a shame. Frankly, being able to make solid returns from our investments is one of the reasons why the pandemic has been bearable for so many investors.
Please spend some time calculating what percentage of your investments and net worth are in capital preservation investments. Now run some various market scenarios to determine whether your allocation makes sense.
With only about 15% of my net worth in lower-risk investments, I will lose a lot of money in the next downturn. Therefore, my plan is to raise more cash and reduce some of my equity investments in my tax-advantaged accounts. I'm about 5% over my target equity allocation of 30% of net worth.
Further, I plan on spending more of my investment gains so that I actually get something out of them. If things get ugly, at least I'll have a nice memory or something tangible to show for!
Here are the 2023 S&P 500 Wall Street forecasts and 2023 housing price forecasts. So far, the returns have been positive. However, you never know the future. Therefore, stay diversified and focus on capital preservation if you've already made a killing!
Invest In Real Estate For Capital Preservation
One of the main reasons why I love to invest in real estate is because it is a less volatile asset that provides shelter and generates income. Stocks, crypto, and other risk-assets are funny money to me. In order to enjoy your wealth, you've got to take profits and spend it on occasion.
With real estate, you can enjoy your home and make money at the same time. And if you've reached the limit for the number of physical properties you want to manage, invest in real estate online.
Check out Fundrise, my favorite private real estate manager. It has multiple funds that predominantly invest in the Sunbelt region, where valuations are lower and rental yields are higher. There is a strong demographic shift towards lower-cost areas of the country due to work-from-home and technology.
Fundrise manages over $3.5 billion and has over 400,000 investors. I've personally invested $810,000 in private real estate funds to diversify my expensive coastal real estate holdings.
Track Your Finances Diligently
A key part of capital preservation is staying on top of your finances. The more you know where your money is going, the better you can optimize your wealth. Winging it is not a good personal finance strategy.
The way I track my finances is with Empower, the web's best free financial app. Not only can you get a great breakdown of your net worth allocation, you can also calculate your expected retirement income and expenses.
I've been using the app since 2012 and have seen my net worth skyrocket, partially due to better wealth management. I'm very focused on capital preservation today after the markets have had such a good run since 2020.
Readers, what are your thoughts on capital preservation at this time? Are you OK with your risk exposure? Or do you plan to increase it or dial it back? What are some other reasons for pursuing capital preservation?
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