Rule No. 1: Never lose money.
Rule No. 2: Never forget rule No. 1.
– Warren Buffett
The world’s most successful investor is keenly aware of the power of compounding and how it works both for and against portfolios—positive returns generate future wealth but negative returns destroy wealth, which is extremely difficult to regain. His cardinal rules ring especially true when it comes to wealth preservation. Accomplishing this, however, is no simple task.
A successful wealth preservation solution must:
- Preserve the purchasing power of wealth;
- Sustain wealth over a timeframe of five years or more;
- Deliver performance consistent with this longer timeframe; and,
- Provide stable returns, to allow for interim capital withdrawals without significantly impacting the longer-term performance.
By these criteria, there is no riskless way to preserve wealth. Traditional wealth preserving assets—so-called “safe” investments—fail to maintain purchasing power and offer little growth; more aggressive growth assets are too volatile. A deeper understanding of the different types of risk and a balanced approach to investing are necessary to successfully preserve wealth.
Rather than seeking to avoid risk, we must aim for an optimal mix of assets, some of which hedge inflation while others offer consistency or provide more growth opportunities.
- Money market and government bonds: While less volatile, these investments struggle to preserve the purchasing power of wealth and are exposed to interest rate risk. Today, money market rates do not keep up with inflation. Long-term bond yields of most developed countries have dropped to their lowest levels in more than 50 years. For many bonds, yields are below the current rate of inflation.
- Inflation-linked bonds, gold and other commodities: Inflation-linked bonds hedge against the risk of inflation; but prior to maturity, prices can vary widely. Gold is often considered the ultimate wealth preserving asset, but the price can move sideways or downward for very long periods. For example, gold fell below $500 per ounce in April 1981 and did not rise back above that level for another 24 years. Other commodities—such as oil, gas, agriculture and industrial metals—are highly inflation sensitive but tend to be very volatile.
- Stocks: While less volatile than commodities, stocks are vulnerable to economic growth risk, and returns to stocks are relatively inconsistent. Over the last 65 years, returns on the S&P 500 have been impressive. But over the past 15 years, two recessions contributed to a meagre 1.6% annualized real return on the S&P 500.
A successful wealth preservation portfolio builds on the strengths of each asset class, while minimizing the impact of where each falls short. Building a truly diversified portfolio means moving beyond asset classes and looking at the underlying drivers of risk and return—inflation, interest rates and economic growth. We can apply insights to the fundamental relationships between these risk drivers to create a portfolio that delivers positive long-term, inflation-adjusted returns with as much stability as possible.
Taking into account the different risks associated with each asset class, we can construct a simplified wealth preservation portfolio. We start with inflation-linked bonds and commodities, which address inflation risk but lack growth opportunities. Adding equities to this inflation-sensitive pairing helps balance the portfolio’s interest rate sensitivity and adds return potential. We have now addressed the first three objectives of this portfolio—to preserve real wealth, to invest over a longer timeframe, and to compensate for this investment horizon.
To achieve our fourth objective, government bonds balance the economic growth risk and add consistency over time. Allocations to these assets are made to balance the risk exposures of each asset. The result is a portfolio in which just over 40% of assets are invested in inflation-linked bonds and commodities (in a 4:1 ratio). Government bonds account for nearly 40%, and the remainder is invested in equities. This wealth preservation portfolio provides a better trade-off between inflation protection, return consistency, and growth potential than any of the individual asset classes.
Wealth preservation strategies have failed historically by either not taking enough risk or taking too much risk in one area. The solution is to balance the risks taken for better outcomes in a full range of market environments. This approach seeks to address the competing demands for preservation of purchasing power, stability of wealth and modest growth—and it goes a long way to meeting the Oracle of Omaha’s cardinal rules.
Kevin Kneafsey is Senior Advisor to the Schroders Multi-Asset Investments and Portfolio Solutions Business