The primary focus for every investor should be capital preservation: protecting the principal investment funds. This is significantly more essential when using other people’s investment funds. After first protecting principal, then an investor’s second priority is capital appreciation.
Many times these priorities get confused; appreciation becomes the top goal and protection of principal is put at risk. This happens when the attraction to potential returns becomes so great that investment discipline is lost. Great examples of this happening were prior to the Great Recession: many real estate investors were chasing appreciation only, purchasing assets that do not cash flow for the hope that they will some day appreciate in value. The plan made lots of money for lots of people, until it didn’t.
Strict Discipline
As wealth builders, it is critical to be willing to forgo the potential rewards of speculation in order to protect your (and your investor’s) investment capital. It takes much discipline to be able to do so, but in the long run, the rewards are greater. Investors that invest with the long-run wealth building mindset and a strict priority of capital appreciation will always fare better in the long run than those seeking short term gains. This happens for two reasons:
1) The prudent investor earns consistent compounding gains over the long term.
Even at the expense of higher returns, the prudent investor can gain immense wealth from consistent returns over time. Warren Buffet, while having achieved many home runs in his career, prioritized investment fundamentals over the potential upside. For example, during the dot-com boom, many people chided Buffett for his stubbornness in not buying into stocks of internet companies. He believed that they were overvalued and that many were essentially worthless. He allowed the criticism, and opted instead to continue to invest in cash-producing companies, organizations that turned true profits and still demonstrated potential growth. Years later, Buffet’s strategy would prove correct; while his companies grew and continued to reward shareholders, most of those internet companies are only remembered by the history books.
2) The undisciplined speculator eventually loses all of his or her initial investment.
When you are chasing the rewards of growth without accounting for the associated risk of losing principal, to the point that the risk of losing principal is too great, you are speculating. During the gold rush, of course, many people found gold. Most people did not. The businesses that thrived during that time are those who supplied the equipment to those speculators! While they may not have “struck it big” like those who found gold, they earned a suitable return for the low risk of supplying equipment (a sure thing, since the demand was quite evident) to those who put it all on the line to find gold (not a sure thing since it was way too possible to lose it all without having gained sufficient return on that investment).
I have engaged many individual stock investors who were very excited about a potential stock. When I reviewed the stock, I learned that there were no fundamentals. Just the potential for growth:
- Their drug may be approved; if it does, they will hit it big!
- They will get enough users and achieve the ultimate social media platform; when that happens, all will hit it big!
- The world will realize that they need this product; once it gets into households everywhere, it will be a big hit!
Each of these scenarios depends on a catalyst that may or may happen. If it does happen, there are great rewards; if it does not occur, there is a great chance that investors can lose their investment.
Our Approach
There is a time and place for speculating. Most times, it is not with investor’s money (unless that is your business strategy). Our company’s approach to real estate is to acquire an income producing asset that:
- Produces cash flow on day one
- Covers all debt service
- Provides consistent returns to investors
- Conservatively estimating, provides a great return from the disposition
Learn more about the 3 Business Models of Multi-Family Investing.
There is massive wealth to be gained from this strategy. The only difference is that risk is always calculated and mitigated, not simply ignored in favor of focus on the potential massive gains.
Caution
Please do not get caught up in the undisciplined investor’s approach to making money. It is risky and often leads to disappointment. Instead, prioritize capital preservation over growth and use that focus to find opportunities that first protect your investment, then create wealth. If you do this, you will never invest in opportunities whose impact from risk far exceed the chance of reward.
Safe Investing!
