The Importance of Preservation of Capital
Most people are much better at making money than they are at saving or investing it. Building an investment portfolio requires three successful activities: generating sufficient income, saving appropriate amounts of that income, and properly investing those savings. The investment decisions that are made have long-term consequences to your portfolio value. The complexity of the process means that an investment portfolio requires thought and attention. Achieving an acceptable rate of return on investment capital does not happen by accident.
Preservation of capital is a fundamental investment principle. Taking an inappropriate risk in the pursuit of extraordinary returns is a common investing error. People understand the concept that higher risks demand higher returns. There is an aspect of this axiom that is often forgotten or ignored. A promised higher return on a higher risk investment is just that, a promise. By definition, the return on the principal invested is at risk. Additionally, the return of the capital is at greater risk in these investments. It can take a considerable amount of time to generate returns in a portfolio that are sufficient to recover from one investment in which the principal is lost.
Importance of Proper Strategies for Investment Planning.
Over a thirty to forty year period, the investment strategies that are utilized will cause tens of thousands of dollars, or more, in lost or earned investment returns. The appropriate strategies for each individual will be dependent on one’s particular situation. Individual goals, earning potential, and risk aversion attitudes all affect the plan development and implementation process. However, there are elements that every well-designed strategy will incorporate. Of the many possible elements of a comprehensive financial strategy, it must include at least:
Stated investment goals
Market averages are just that, averages. While they provide good guidance metrics, averages by definition contain both highs and lows. An individual will have certain personal expectations and time frames that are independent of market timing constraints. Each investor has differing risk aversion perspectives. Any strategy must leave the investor with a measure of day-to-day comfort concerning his or her portfolio. Individual investment decisions must be weighed against their fit with the stated goals of the investor.
Tax deferral and avoidance strategies
Tax deferral and avoidance strategies are legal. Tax avoidance practices are not. The related principles of 1) time value of money and 2) compounding have enormous implications to portfolio growth over time. Successful execution of strategies that avoid or defer taxes is essential.
Diversification of risk strategies
This principle is recognized as essential to prudent portfolio management. The Nobel Prize was awarded to Harry Markowitz in 1990 for his work in illustrating the power of diversification in investment portfolios. Recent turmoil in the financial markets underlines the importance of this tool of diversification. Protection from normal market cycles that determine long-term returns is achieved by dividing investment capital between various asset classes.
Hedges against deflation and inflation
The ultimate determination of the value of an investment portfolio is not its net asset value or rate of return. The true standard is the purchasing power of the assets held in the portfolio. The external dynamics of deflation and inflation play significant roles in long-term true value of investment portfolios. The investment principle of compounding applies either positive or negative leverage to a portfolio. The investment and diversification strategies determine which of the two results are experienced.
Interest Rates and the Precious Metals Markets
An extraordinary period of low interest rates has existed over the past decade. These rates are artificially created and supported by current government policies. The most recent activity of “quantitative easing” has sustained low rates by massive government purchasing of debt. The net result of this effort is trillions of dollars in new U.S. debt.
The consensus of virtually every economist and financial planner is that this period of low rates and high government debt will result in a period of higher inflation at some point in the not too distant future. As a result of heightened concern over inflation, they are adjusting investment strategies and portfolios to provide hedges against inflation. Well-proven theories provide guidance as to the manner in which various classes of assets perform in periods of high inflation. Primary objectives of inflation hedges are to preserve and enhance the portfolio’s true purchasing power or value during and after effects of inflation.
Effective Hedges Against Inflation
There are three commonly accepted asset classes that provide effective protection against inflation. These are debt, real estate and precious metal. Some strategies combine debt with real estate and precious metal investments. The underlying theory is that the debt used to purchase either asset will be paid back with devalued dollars, enhancing the effective return. Each of these hedges has its own advantages and disadvantages.
The term precious metals includes the commodities gold, silver, platinum and palladium. Individuals have accepted gold and silver throughout history as assets that retain value. An oft-quoted example is that the value or purchasing power of an ounce of gold buys a good suit of clothes today, as it would have for Roman senator or a knight of Henry VIII. Gold and silver served for centuries as currencies of last resort in times of upheaval and turmoil. Platinum and palladium are produced in sufficient quantities today to be included in the global precious metal market.
Prices of Precious Metals
If one focuses on the precious metals markets, it is seen that they are experiencing all time record high prices. In economic situations where inflation is accompanied by perceived local or global instability, precious metals are favored investments. Inflation is currently a major factor in the recent rise in precious metal prices. There are, however, other dynamics. Increasing industrial uses of the commodities is a significant factor.
The price of gold has increased by roughly 300% in the past five years. Silver, platinum and palladium have all seen substantial increases in prices. As these products are actually used in commercial processes, supply and demand can cause periodic spikes and highs in pricing. In the 1980s the Hunt brothers in Texas caused a spike in commodity prices of historical proportions. Rather than active trading, purchases of precious metals for investment portfolios are most concerned with long-term price trends and dynamics.
Precious Metals as Investments
A significant and growing component of the investment community has increased the proportion of precious metals they recommend to be held in diversified investment portfolios. Many of these advisers see a continued rise in the prices of all precious metals. In addition to inflationary pressures, they present a number of persuasive factors for continued price increases. Overall supply and demand influences are a major consideration as commercial applications using precious metals continues to grow.
For the individual investor, precious metals have some perceived disadvantages. These include the lack of any dividends and the need for secure storage. Other vehicles for precious metals investing have become popular in meeting increased demand. These include:
A small percentage of investors purchase physical holdings of the refined commodities. A smaller percentage takes physical possession of the precious metal. There are firms that facilitate these purchases and offer secure storage options.
The U.S., Canada, China, Australia and other nations mint coins that are sold at market prices. Firms such as Monex have created sophisticated methods for investors to purchase and store bullion coins. There are also strategies for leveraging bullion purchase with debt.
Exchange traded funds and notes
Financials instruments that can be traded on exchanges are increasing popular. Commonly referred to as ETFs and ETNs, these products are backed by physical holdings of a specified precious metal. Similar to other securities, they also present the opportunity to use leverage. The risks in these particular investments can be quite high.
Stocks of mining companies
The value of the securities is directly influenced by the value of the commodities they mine. Reserves held by the mining companies are an indirect way to participate in the increase in their value.
Commercial enterprises use futures contracts to control the costs of their raw materials. Individual investors can participate in this market. Futures contracts are considered the domain of sophisticated investors. They are inappropriate for the goals of many long-term investment portfolios.
One additional advantage for individual U.S. investors may be found in holding precious metals investments in one or more tax-advantaged retirement account. IRAs may be an excellent option. There are specific restrictions and IRS regulations that must be adhered to in placing precious metals within an IRA. These issues are straightforward and are not a major hurdle to investing in precious metals through an IRA. One can even invest through a 401k plan with additional processing requirements.
Once considered an exotic investment suited only for sophisticated or eccentric investors, investing in precious metals has become mainstream. There are long-established, stable firms that provide guidance on the intricacies of investing in this asset class. Diversification utilizing precious metals as an asset class is a practical decision for any long-term investment portfolio.