Preservation of capital is a conservative investment strategy where the primary goal is to safeguard capital and prevent any loss within the portfolio. This strategy necessitates investment in the safest short-term instruments, such as Treasury bills and certificates of deposit. Capital preservation is also commonly known as preservation of capital.
Achieving Peace of Mind with Capital Preservation
Investors place their funds in various types of investments that align with their financial goals. An investor’s objective or portfolio strategy is influenced by multiple factors, such as age, investment experience, family responsibilities, education, annual income, and more.
These considerations help determine how risk-averse an investor may be. Common investment objectives include current income, capital growth, and capital preservation.
Key Takeaways
- Preservation of capital is a conservative investment strategy aimed at safeguarding capital and preventing any portfolio losses.
- Implementing capital preservation strategies requires investing in highly secure short-term instruments, such as Treasury bills and certificates of deposit.
- One significant drawback of capital preservation is the impact of inflation on the return rates of “safe” investments over extended periods.
Assessing Risk Tolerance and Investment Goals
The current income strategy aims to invest in securities that generate prompt returns, such as high-yield bonds and high-dividend stocks. On the other hand, the growth strategy targets stocks emphasizing capital appreciation with little consideration for current income.
Growth investors are willing to endure higher risks and invest in growth stocks characterized by high price-earnings (P/E) ratios. Nevertheless, a popular investment goal for many portfolios is the preservation of capital.
Securities chosen for capital preservation carry minimal to no risk, resulting in smaller returns compared to current income and growth strategies. Capital preservation holds particular importance for retirees or those nearing retirement, who may depend on their investments to cover living expenses. These investors prioritize safeguarding their existing capital and therefore typically opt for investments with minimal risk such as U.S. Treasury securities, high-yield savings accounts, money market accounts, and bank certificates of deposit (CDs).
A significant portion of investment vehicles utilized by investors focused on capital preservation are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. In many instances, these investors might only be investing their money for the short term.
Recognizing Drawbacks
A key drawback of the capital preservation strategy is the subtle yet substantial impact of inflation on return rates from “safe” investments over lengthy periods. While inflation may not seem to affect returns significantly in the short term, it can severely diminish the real value of an investment over time.
For instance, a modest 3% annual inflation rate can devalue the inflation-adjusted worth of an investment by 50% in just 24 years. Although the nominal amount is maintained, the interest accrued is typically insufficient to counterbalance the gradual erosion in purchasing power caused by even mild inflation. Consequently, you may lose value in “real” terms, despite having the same nominal amount of cash.
For this reason, investors seeking to safeguard their purchasing power over time may find it advantageous to invest in inflation-adjusted instruments, such as Treasury Inflation-Protected Securities (TIPS) issued by the U.S. government.
Related Terms: Treasury bills, certificates of deposit, current income, growth strategy, risk tolerance.
References
- Federal Deposit Insurance Corporation (FDIC). “Insured or Not Insured?”
