Capital Preservation Paul, Part II

On the last day of March, we launched our own, far more interesting version of March Madness, namely, an investment contest. Our contest features the Investing Final Four, that is, the four main kinds of investors I’ve encountered in a long and checkered career in the financial advisory business. But instead of competing for something pathetic and fleeting, like hoop glory, our contest is for all-the-marbles, i.e., wealth. And as we all know, wealth is better than sex, better even (I know this is controversial) than Pappy Van Winkle.

Keep in mind that this isn’t one of those simple investing contests where everyone owns nothing but U.S. large cap stocks. All our contestants have built broadly diversified investment portfolios and all follow exactly the same target asset allocation. Keep in mind, also, that we are ignoring the impact of taxes since each contestant has a different tax profile.

The reason we’re mounting our contest is to grapple with an apparent conundrum. I’ve argued that almost every investor should focus on capital preservation. But I’ve also acknowledged that capital preservation investors often seem to lose out to less thoughtful investors. This happens because capital preservation investors trail more excitable investors in strong markets and then often fail to catch up in bad markets. That annoying result occurs because excitable investors panic and sell out before the bottom, while patient, capital preservation investors remain invested through thick and thin.

So why would anyone invest for capital preservation? We’ll find out by observing the results of our exciting investment contest, and we’ll start by meeting the intrepid competitors:

Lauren Buffett is the extremely low-profile sister of Warren Buffett. As sisters are wont to do, Lauren ignored her brother’s advice to buy the Vanguard S&P 500 Fund and be done with it. (When I asked Lauren about this, she replied, “Face it, Warren is full of dumb advice.”) Instead, she built herself a very nice, highly diversified portfolio. Like Warren, however, Lauren is a world-class investor, among the very best of all time. We’re including her in our contest not because we expect that anyone can beat her, but because we might learn something by watching how she beats us.

Patient Patty is a buy and hold investor. Patty has adopted this strategy not because she’s highly confident in her investment picks, but for the opposite reason. She knows that if she watched the market and obsessed over her portfolio she would be tempted to do all the wrong things. So, instead, she pays not the slightest attention to either. Because Patty incurs no advisory fees and pays very little in taxes, she has managed to give herself a very nice tailwind in our contest.

Typical Tom is like 95% of all investors, which is to say that he invests emotionally. Tom doesn’t understand that that’s what he’s doing, of course, he thinks he’s a thoughtful, insightful investor. But during Bull Markets Tom gets wildly excited, certain he’s about to become fabulously rich. He buys and he buys and then he buys on margin. Alas, during the inevitable Bear Market, Tom flies into a panic, certain he’s about to lose his shirt. He sells and sells until he has little left to sell and is mainly in cash.

Finally, we have Capital Preservation Paul. Paul worries constantly that his capital is at risk. He worries during Bull Markets that prices are too high and he worries during Bear Markets that he’s going broke. So he manages for capital preservation, giving up something on the upside in the hopes of making it up on the downside. He pays high advisory fees and his taxes aren’t inconsiderable. What in the world is this man thinking?

Every contest needs a playing field, of course, and our playing field will be established by Mr. Market. Note, importantly, that Mr. Market isn’t a contestant, he’s just the mechanism that provides the framework for investing capital. Way too many people make the mistake of thinking that Mr. Market is their competition, but—guess what?—Mr. Market isn’t a person. He doesn’t build wealth and he doesn’t spend it.

If Mr. Market is offering strong returns, then our contestants will, by and large, achieve strong returns, too. If Mr. Market is offering weak returns, our contestants will earn weak returns. In each case, they might beat Mr. Market and they might not. But it doesn’t matter because he’s not their competition. Our competition as investors is, in part, other investors. If we’re in a footrace it’s not the clock we’re trying to beat, it’s the runners in the lanes beside us.

But even more than other investors, our real “competition” is the goal of achieving our individual objectives. We can beat Mr. Market regularly and still not achieve our objectives, and we can lose to him regularly and still meet those goals.

Mr. Market starts our contest with a portfolio of $100,000. At the end of Year 1, a so-so market, Mr. Market’s broadly diversified portfolio has risen 4%, giving his portfolio a value of $104,000. But then Years 2 and 3 are very strong markets, with even diversified portfolios rising 15% and 20%, respectively. At the end of Year 3, Mr. Market’s portfolio is worth $143,520.

Alas, Year 4 is a Bear Market, with equity indices down very badly and even Mr. Market’s diversified portfolio down 20%. The value of that portfolio is now below where it was at the end of Year 2 ($119,600) and stands at $114,816. Finally, Year 5 represents a partial recovery from the Bear, with Mr. Market’s portfolio rising 10% to finish the five-year market cycle at $126,298.

Next week we’ll see how the contestants navigated these complicated market environments.

Next up: Capital Preservation Paul, Part III