Why Capital Preservation is a First Principle

Most 401k presentations include a slide that illustrates the importance of dollar-cost-averaging and the benefits of a buy-and-hold approach to investing over the long-term. 

The point is typically supported by data indicating that most investment gains are created by a relatively small number of days during which the markets experience big moves. The conclusion is that market timing is futile and that it pays to just hang-in there and avoid the performance drag that results from missing-out on the handful of key days. 

There are a couple of problems with this logic. First, the vast majority of individual investors do not stay invested for any meaningful period of time, and their investment results reflect this fact. 

Second, individual investors would be better served by a slide that demonstrates the importance of capital preservation. 

The economist A. Gary Shilling demonstrates this capital preservation point beautifully in his book The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.  

In the book, Shilling examines total stock market returns from the S&P 500 index during the period beginning December 1946 and ending February 2010. 

The investor who is fully invested and long during the entire period has an average annual return of 8.7 percent. 

However, the investor who was out of stocks during the 50 strongest months and the 50 weakest months had an average annual return of 9.4 percent (assuming they were long and fully invested all other months). In other words, sitting out the bull months and the bear months results in performance that is better than the fully invested scenario. 

Remaining long during the 50 best months while somehow managing to sit-out the 50 worst months results in an average annual return of 15.5 percent. 

Interestingly, missing the 50 best months and managing to be short during the 50 worst months produces an average annual return of 15.6 percent. 

As Shilling concludes, while it is of course good to be in the market during the best days or months, it is even better to be out of the market (or ideally short the market) during the bear periods. 

This boils-down to capital preservation and Warren Buffett’s first rule of investing which is don’t lose money (and the second rule, by the way, which is not to forget rule number one). 

The reason is that it is way harder to catch-up after a loss or “capital impairment.” Getting back to even after the 50 percent loss many people experienced in 2008 requires a doubling of one’s money. 

Repairing impaired capital is even tougher in a low return world. This is why capital preservation--particularly for retirees who must deal with sequence of returns risk--is a first order principle of investing.