During one’s investment journey, there will come a time when you’ve obtained good wealth. For example, during the pandemic, several companies were solving critical problems the world needed and their valuation went through the roof. Examples of these companies include Amazon, Zoom and Moderna. Zoom helped students continue their lessons with their teachers remotely. They also helped office workers to work from home. Moderna was among the first to create an effective mRNA vaccine against COVID. The Pandemic also changed how people shop. To avoid getting into stores and malls, many consumers used e-commerce shops like Shopify and Amazon. If you were so lucky to have invested in these companies prior to their rise, you would have done well during that period. The problem most of us faced in this situation is not realizing in rising so fast, your portfolio becomes unbalanced and much less diversified. In addition, some of these easy gains might not last once the Pandemic or special business opportunity disappears and growth rate returns to normal and revert to the mean. We will go over some important lessons and what steps one can take to preserve wealth.
One important lesson with the example of the pandemic is any sudden gain in wealth may have some element of luck. No one could’ve predicted the pandemic. Instead of thinking you are an investment genius and start to buy all kind companies it is more prudent to be modest and continue to be analytical and disciplined in making investment decisions. Without careful thought and planning, the wealth you have suddenly achieved can also easily vanish due to taking on risky investments.
Once wealth is obtained one’s investment objective changes from growth to wealth preservation. Rather than chasing growth and taking on more risk, keeping what you’ve obtained takes on critical importance. The reason why growth is less important is the wealth you’ve already obtained can generate a meaningful amount of income or new wealth all by itself at low risk. Assuming market average long term returns of 10%, for example, with $1,000,000 wealth, at that rate generates $100,000 annually if invested in the diversified S&P 500 index ETF on an average year. On the other hand, if the million dollar is invested in a couple of risky companies and if they unfortunately all suffer enormous losses and misteps, the million dollar can be wiped out and you would have to start over. For a young person int their 20s with long time horizon, it’s very possible to recover. Starting over when you are passed age 50 gets harder with less time for investments to grow.
The key to wealth preservation is diversification and reducing risk exposure. You can diversify into difference classes of investments: stocks, real estate, or bonds. The ratios will depend on the individual. By spreading wealth to difference classes of investment, the investor stand a better chance of preserve wealth since it is unlikely that all classes of investment suffer big losses at the same time.
For the stock class, you will need to diversify into a large pool of strong companies in different industries. One or two companies might go bankrupt but for hundreds of companies to going extinct is an unlikely event. Therefore a stock portfolio that is diversified such as the S&P 500 ETF can reduce the single company failure risk.
In the real estate bucket, you can invest in rental property that generate rental income. Property value tend to be a lot less volatile than stocks and its value trend up at the rate of inflation. Unlike a stock, it will not drop 20% in value in a single day. Owning actual real estate and maintaining it may be too much work. An alternative is to own REIT ETFs. These ETFs invest in companies that own apartments, homes for rent, indoor and outdoor shopping malls, data centers, warehouses and commercial real estate. They provide exposure to real estate without the headache of looking for tenants and fixing a leaky roof or toilet in the middle of the night.
For bonds, the highest quality bonds are U.S. government AAA rated bonds. The US government sells bonds at different maturity to fund the operation of the country. You can purchase bonds directly from Treasury Direct website https://www.treasurydirect.gov/savings-bonds or your broker. The I Bonds are a special bond that is design to protect against inflation. It combines a fixed interest rate with an inflation based rate and the rate resets twice a year. As of the time of this writing, the I Bond has a yield of 6.89%. The minimum account balance is $25 in the TreasureDirect account. The maximum you can buy each calendar year is $10,000 electronic I bond and $5,000 in paper I bonds.
Bonds cans also be purchased via an ETF. iShare sells ETFs for various maturity curve:
SGOV 0-3months, SHIV 0-1 Yr, SHY 1-3 Yr, IEI 3-7 Yr, IEF 7-10 Yr, TLH 10-20 Yr, TLT 20+ Yr, GOVZ 25+ Yr. GOVT 1-30 Yr (the entire yield curve).
Buying a bond fund is different than buying bond directly. A bond fund holds a pool of bonds. It risks dropping in value. The value of a bond fund is not guaranteed. The reason is in a bond fund, the bonds have to be periodically sold and new bond has to be purchased. In contrast, with a direct purchase of a U.S. treasury bond, the value is guaranteed if one holds it through the bond’s maturity. In a rising interest rate environment as we are in now in 2023, bond funds can suffer lost of value. We will look at the iShare IEF bond ETF which has a range of 7-10 year maturity. It’s 2023 as of this writing. The fund will need to hold bonds that mature 7, 8, 9, and 10 years from 2023. It would consist of bonds maturing in 2030, 2031, 2032, 2033. As we near the end of 2023, it will need to sell its holdings of the 2030 bonds to maintain its portfolio of bonds with 7-10 Yr maturity. After selling the 2030 bonds and it will need to buy 2034 bonds. In a rising interest rate environment, the interest rate at time T will be lower than some time T in the future. It will be buying bonds at lower interest rate which equates to high price and selling them at some time in the future when interest rate is higher. Existing bonds’ price price since they have a lower interest rate. Their price drop to produce a similar yield matching the current higher interest rate. With interest haven risen, the fund needs to sells the 2023 at a lower price to attract buyers of the bond which had a lower interest rate compared to the current interest rate. After selling the 2023 bond as a low price, it is buying the 2034 bond. The bond fund is buying high and selling lower. Buying bonds directly in this environment may outperform a bond fund with similar maturity.
To recap, take action to focus on preserve wealth after you have reached some level of success and take some risk off. Diversify to different classes of investments goes a long way toward wealth preservation. All the best to you in your investment journey.