Capital Preservation At All Costs

The Darwinian theory of evolution, which signals the importance of adaptive survival strategies, underlines the most significant rule of engagement: self-preservation. Indeed, protection of what one possesses has been the prime driver of all functions, economic or otherwise, throughout the ages. In every sphere of human activity, at every level, self-preservation is the most dominant force. This is, for our purposes, especially relevant for investments. Preservation of what we have—capital, in all its forms—is our top-most priority. And not without reason.

Investors normally do not wish to compromise what they have. The possibility of creating an edifice on the extant foundation is usually explored afterwards. Wealth accumulation, of course, is the ultimate destination, but that comes only when you are sure that your base is perfectly protected.

An investor who takes capital preservation seriously, thus, must devise his asset allocation strategy in keeping with this specific requirement. No excess baggage of risk, no needless adventurism, no ultra-creative investing style. On the contrary, he must be extremely cautious when it comes to high-risk assets. Naturally, he will need a bit of fixed-income securities to help achieve his goals.

The niggling issue, as you will no doubt agree, is returns. In other words, a savagely conservative asset allocation plan needs to be followed so that capital is not compromised. Else, the old chestnut—with low risk comes low returns—will be rendered quite useless. Remember, at the far end of the spectrum is the other age-old maxim: high returns are a function of high risks. With heftier risks come (the probability of) superior gains. It is as simple as that.

Gone Guarantee

To explain matters a bit more, let me take you through the fixed-income options that are usually found around us. The queue is quite long, and starts with postal deposits. These are the ultimate administered-rate savings products that are available. Investors, especially the middle class, have trusted these (the entire crop of small savings schemes to be precise) for decades.

Close to these come other sundry guaranteed-return schemes. Sovereign Gold Bonds, for instance, are completely trusted too. Investment done by way of bonds of National Highway Authority of India (NHAI) or Rural Electrification Corporation (REC) may also be viewed as part of the list, although there is a strong tax-saving element on this front.

Bank deposits, however, are somewhat different in terms of perception, particularly in the context of the government’s recent decision to increase deposit insurance to Rs 5 lakh from Rs 1 lakh. The fear of compromising our bank deposits has plagued many of us at various points in time. There have been instances of government intervention; popular perception has taken a dip on occasions. Yet bank deposits remain at the heart of our overall savings.

The numero uno status of deposits is being somewhat threatened these days. Mutual funds are gradually eating into the deposit base Indians have built over the years. The trend in favour of funds (“managed” products, all of which are subject to market risks) is expected to grow stronger in the days ahead. However, that will result in growing market risks too. The latter, in fact, are now quite firmly an inseparable part of the modern investor’s life. These also collectively reduce the possibility of fully preserving capital across market cycles.

A few points may be raised in this connection:

• Investors who assign the highest priority to capital preservation need to know about the tragic flaws of such a strategy too.
• Returns may be seriously hit if enough risks are not taken. Low returns generated by debt securities or similar instruments are at any rate worsened by the impact of inflation. 
• There is the other devastating impact too—taxation. The impact of poor returns from a low-yielding portfolio will be compounded when gains are taxed. Remember, in the world of investments, practically nothing is tax-free. Even debt, its sure-fire nature notwithstanding, attracts tax.

The effect of taxation gets compounded for those in the higher tax brackets, especially the high networth individuals (HNIs) who are sometimes more adventurous when it comes to product selection. India, incidentally, is believed to rank among those emerging economies where tax rates are on the steep side.

While some sops have been rolled out to address issues related to corporate tax rates, the average individual must still grapple with stiff levies. In sum, HNI or otherwise, the Indian taxpayer is not in the most comfortable of situations.

And insofar as the debt portfolio is concerned, the post-tax value-addition is negligible. In other words, debt remains nearly irrelevant for most of us. I am particularly drawing investors’ attention to the overall returns generated by actively managed debt these days. As we stare at the possibility of changes in the interest rate cycle, the scenario is not going to get any better soon.

Keeping The Foundation Intact

The above mentioned points assume significance in the current investment clime. This is, after all, an era marked by extreme volatility in the markets. Interestingly enough, we have witnessed the emergence of newer financial products in recent days; an array of contemporary options (cryptocurrency, for instance) now tempt the investor.

Be that as it may, many of these options are being aggressively positioned by the product manufacturers and are also being commoditised to a great extent. Such products are priced too in a variety of ways. Some also carry loads of risks.

The solution, I believe, lies in the regulatory stance on the nature of capital preservation. As for managed products, “capital preservation-oriented” options seem to have received a certain level of official sanction. In other words, the authorities do not want product manufacturers to offer guarantees of any sort. Even assurances related to protection or preservation are to be viewed strictly.

“How secure is my capital?” remains a standard ask. Every interaction with a product manager or an intermediary, I guess, yields this primary poser. And every time the curious investor must be given a satisfactory response. A failure on that front will lead to supplementary questions, and in more ways than one, inappropriate selection. At the end of the day, clarity is sacrificed at the altar of choices. Do we want that to happen? You have a thumping ‘No’ for an answer.

The average investor, mind you, has experienced enormous crises across market cycles, especially so in the last couple of decades. While I will not mention any of them in particular, I do wish to state that each crisis has destroyed wealth to a very large extent. The ordinary John Doe has probably emerged stronger and more confident after every difficult phase. Yet capital preservation has remained his cornerstone—an article of faith that cannot be trifled with at any cost.

The author is Director, Wishlist Capital