Capital Preservation is the Key

Ironically, the success of the economic recovery creates the need for caution in the markets. 

I believe that this is “a time for caution” as it seems to mature economy’s and expected rising interest rates should require a more cautious investment strategy. 

This is because central banks will be removing some of the highly favorable financing conditions of the past two years i.e. raising short rates. Traders are worried about the impact of rising rates.

But First, What is the Preservation of Capital?

Preservation of capital is a conservative investment strategy where the primary goal is to preserve capital and prevent loss in a portfolio. This strategy necessitates investment in safe investments, such as treasury bills, real estate, structured notes with capital guarantees, and certificates of deposit.

Understanding Preservation of Capital

The key to understanding the preservation of capital is understanding the family needs and building a strategy for the family, based not only on their aspirations but also on their capacity for exposure to risk and understanding what the implications are if the investments lose value in the short or medium term. 

Investors should hold their funds in various types of investments according to their investment objectives. An investor’s objective or portfolio strategy is dictated by several factors, including age, family responsibilities, education, annual income, etc.

The Academic process backed by research and implemented by qualified professionals has six components: financial management, asset management, risk management, tax planning, retirement planning, and estate planning.

Financial Management 

The purpose of financial management is to understand the client, their income and expenses, assets and liabilities, identify strategies and techniques to optimize short- and midterm cash flows, assets, and liabilities. 

Asset Management 

An investment management strategy provides the framework for investment decisions. It ensures that the decision-making process concerning the management of your portfolio is consistent, even when unexpected market fluctuations tempt distraction. The development of an effective investment management strategy is the basis for building a family’s future. 

Risk Management (Profiling) and Stress Testing 

The “Risk Profile” is an evaluation of an individual’s willingness, capacity, and ability to take on risks. A risk profile theoretically, therefore, is important for determining a proper investment asset allocation for a portfolio

Controversially, it is accepted that if an individual expresses a desire for the highest possible return and is willing to endure large swings in the value of the account to achieve it. This person would have a high willingness to take on risks and is a risk seeker. However is it really clear to the investor that the risk the investor is taking is not achieving a high return over time with volatility in the process, But actually taking on the risk that he will in high probability expose himself to the possibility of losing all his money. 

The use of scenario techniques enables stress scenarios (what-if scenarios, for example, what if the dollar loses 20% of its value, what if there is a crisis in the stock market, etc). In addition to realistic economic performance scenarios – to be factored into decision making. Scenario-based asset allocation can therefore be an effective tool for constructing stress-resilient portfolios.

While risk profiling and scenario management are very important the priority is to work on the individuality of investors and their specific life goals, dreams, values, and aspirations and align the asset allocation accordingly. 

Tax Planning

The principles of tax planning form an integral part of any wealth-building strategy. The overall objective is to structure clients’ affairs to legally minimize the amount of tax they have to pay. They can accomplish this by adhering to what we call the 4D’s of taxation: 

  1. Deduct – maximize all tax deductions and credits. 
  2. Defer – defer paying tax if possible. A tax dollar deferred is often a dollar saved. 
  3. Diminish – position investments in investment vehicles, which attract the least amount of tax, having full regard for your risk tolerance and asset allocation strategy. 
  4. Divide – split income among family members to the maximum degree possible while considering other personal objectives. 

Retirement Planning

By identifying all sources of income and all expenses and recognizing the timing of each, you can identify in any year when the client will have a shortfall (more expenses than income). In those shortfall years, the monies invested can be used to cover these shortfalls. These controllable variables include: 

  • Controlling expenses as much as possible. 
  • Reducing taxes 
  • Improving the rate of return on the investment portfolio by changing investment strategy 
  • Reducing or eliminating one or more of your goals in the future if need be. 

By making one or more of these changes, the client can go from a shortfall to a surplus. When you have a surplus (identified as an “Estate”) it means that you would achieve all of your goals and objectives, with something left over at the end of your planning horizon 

Estate Planning 

There are four Principles of Estate Planning that are fundamental: 

Principle #1: provide for your own needs for life – ensure that your personal lifestyle needs are provided for so that you don’t have to ever worry about running out of money. 

Principle #2: safeguarding your estate to the maximum extent possible – by building an investment strategy that can sustain your lifestyle. 

Principle #3: protect your estate from the erosion caused by taxes and other expenses. 

Principle #4: distribute your estate in an orderly fashion 

In addition to these principles, you have some specific concerns that must be taken into consideration to ensure that your estate planning strategy fulfills your personal goals and objectives. 

When financial uncertainty strikes, either because of local or national events such as economic recessions, many consumers take a cautious approach to managing their money and shift their focus toward playing it safe and keeping their finances afloat until circumstances improve.

In fact, financial planning can help you turn uncertainty into an opportunity to actually increase your financial security and take strong steps toward a brighter future. 

About the Author
Dan Dobry was the founder of the Union of Financial Planners in Israel (UFPI), served as the first Chairman and President of UFPI. Dan was the Global Council Representative for Israel for the Global Community (FPSB) from 2012 - 2018 and from January 2019 is a member of the Committee for Standards and Qualifications for the European Union (SQC).