The concept of capital preservation is a term used in the financial industry to describe a very specific financial objective: Protecting the absolute monetary value of an asset!
Sometimes, but less often, capital preservation is taken to mean protecting the inflation-adjusted purchasing power of an asset so that a given pile of money can still buy the same goods and services by the end of the holding period. Hence in this paper, we seek to answer a central how question: How do we focus on real wealth and capital preservation?
Impending Economic Meltdown
The historical pattern of a 10-year rhythm of cyclical financial crises looms as a menacing storm cloud over the financial markets. For example, the 30% US market crash of 1987, in which investors lost 10% of 1987 GDP, was set off by the 1985 Plaza Accord to push down the Japanese yen with an aim of reducing the growing US trade deficit with Japan.
This was then followed 10-years later by the Asian financial crisis of July 2, 1997, with all Asian economies going broke, and some stock markets such as Thailand’s losing 75% of their value, and Hong Kong having to raise its overnight deposit rate to 500%, trying to defend the fixed exchange rates of their currencies.
A decade later, in 2008, the US economy suffered its worst slump since the Great Depression of the 1930’s. The main culprit was a housing slump. During this period, US consumers were deprived of expanding their wealth as personal income and wealth in the US declined by almost 7%.
Figure 1: Staggering Global Debt Level
Now in 2018, the hidden dangers are looming over the next global debt-driven financial crisis that threatens to put an end to our past decade-long liquidity boom that was generated by excess money printing policies adopted by global central banks (refer Figure 1).
Figure 2: The Decline in US Dollar
Source: Google Finance
What is clear is that in all these cases, a point was reached where the scale tipped to reverse the irrational rise in asset prices beyond market fundamentals. Market analysts call such reversals “paradigm shifts”. For example, one such shift was a steady fall in the exchange value of the US dollar, the main reserve currency in international trade and finance, to cause a sudden market meltdown that quickly spread across national borders through contagion (refer Figure 2 above).
The outcome as we knew were the selling frenzy of assets in stronger markets such as the US, Hong Kong, and China to try to save hopeless positions in distressed markets such as Russia and India. This created an environment in which global financial markets after 2010 onwards moved with less long-term conviction and are more sensitive to short-term speculative views accentuated by derivatives and algorithmic trading.
So what can investors do in such an environment? Anticipating the unexpected and reducing downside risk are key strategies for protecting your hard-earned savings in this ‘new normal’ economic reality.
Focus on Capital Preservation
These days it’s become important for investors to draw a few distinctions between the short-run and the full-market cycle – which is commonly measured as the market peak to peak, or trough to trough.
Figure 3: Short-run Asset Life Cycle
In the short-run, market returns tend to be influenced most by a combination of investor sentiment, risk preferences and price momentum, all of which are interrelated (Refer Figure 3 above). Over the course of a full-market cycle, however, valuations are ultimately what matters. In the short-run, investors are often penalized for following the familiar approach of buying low and selling high. Yet a full market cycle tends to be enormously forgiving to investors who decide to reduce their risk when markets are at or close to their high point. This is true even if investors do this a little bit too early, and miss out on the final stages of upside.
Investors always face the question of what to emphasize in their portfolios – capital growth or capital preservation. You can’t do both! In this paper, I want to deal with the latter.
Hard Assets Contribution to a Portfolio
There is one consistent fact across investment strategies: they aim to obtain the greatest possible return while incurring the least risk. Whether a strategy is set to maximize long-term returns, short-term gains or even outperform a given benchmark, implementation varies widely. And finally, measuring the success or failure of an investment strategy completely depends on the methodology used. It should not come as a surprise, then, that the role and effectiveness of hard assets within a portfolio is a hotly debated topic.
Hard assets are investments with intrinsic value such as oil, natural gas, gold, silver, farmland, natural colored diamonds and commercial real estate. Broadly speaking, hard assets are seen as performing two main functions in the context of capital safeguarding: 1) it protects purchasing power and 2) it mitigates risk in a portfolio.
However, the lack of specificity as to what those really mean has created not only confusion but also disillusionment among some investors. It has led to multiple interpretations and has made it difficult to quantify hard assets success in providing such benefits.
Considering that investment strategies has different risk tolerant levels and even definitions, this paper aims to clarify the benefits hard assets adds to investment portfolios in a precise manner and present measures to quantify its effectiveness. This analysis shows that investors should use and invest in hard assets not in isolation but as a strategic component in their portfolios that will:
- Protects their purchasing power (taking into consideration local inflation rates as well as currency fluctuations).
- Reduces portfolio volatility.
- Minimizes losses during periods of systemic market risk (i.e., large shocks that affect multiple economic sectors/world regions).
- Serves as a high-quality, liquid asset that can be used when the selling of other assets can be costly or cause large mark-to-market losses.
Hard Assets Role in Preserving Capital
In addition to potential losses in asset prices, investors’ capital is affected by the erosion of purchasing power through inflation and, in a global context, the relative value of the currency that serves as the benchmark for an investor. While the level of inflation and the value of a currency should be closely related, in practice the two may diverge – imperfect measurements, government interventions and trade restrictions all contribute.
In this sense, hard assets negative correlation with currencies, particularly the US dollar, and its relationship to global inflation as we explain below – make it a particularly useful tool for protecting purchasing power over the long run. Hard assets effectiveness is hotly debated in part due to lack of clarity about the role it plays. We aim to clarify how hard assets protect purchasing power and reduce risk.
Hard Assets as an Inflation Hedge
Figure 4: Tangible Assets Retains Value Source: CNBC.com
A common argument for buying hard assets is that it is seen as an inflation hedge. The problem, however, is that not everyone agrees on what this really means. A recent publication by KPMG in 2017 stated that wealth managers have reported that their clients are increasingly interested in direct investments in timberland, farmland, mines and real estate (refer Figure 4 above).This is due to the fact that tangible assets maintain their value even as prices rise and the purchasing power of the dollar falls.
In practice, consumer price indices measure ‘representative’ baskets of goods that may well reflect a general price trend, but these will likely not reflect everyone’s experience of inflation. Furthermore, when investors say hard assets is an inflation hedge, do they actually mean it hedges inflation in the US, Europe or elsewhere?
This paper summarize hard assets role as an inflation hedge as follows:
Hard assets, especially today, should be understood in the context of global inflation: an asset that responds to price pressures in developed markets as well as in emerging markets.
Hard assets are widely used in many emerging markets, especially in Asian and Middle Eastern countries, as a means to preserve and transfer wealth from one generation to the next.
Hard assets help to preserve capital over the long run. While there is evidence to suggest that the hard assets price rises more during periods of high inflation, as discussed in the impact of inflation and deflation in the case for hard assets.
To conclude, there is still a great deal of debate regarding the function which hard assets play in a portfolio. Misunderstandings about hard asset properties have given rise to an abundance of articles contesting its role as an inflation hedge, currency hedge, and tail risk hedge, among others.
Conceptually, real wealth preservation is simple. The challenge comes with actually delivering it, consistently and well, over the long term. Hence, this paper aim was to properly define these functions and use appropriate measures to explain the benefits hard asset as a means for preserving capital and purchasing power but also to manage portfolio capital risk.