Preservation of Capital
What Is Preservation of Capital?
Preservation of capital is a conservative investment strategy where the primary goal is to preserve capital and prevent loss in a portfolio. This strategy necessitates investment in the safest short-term instruments, for example, Treasury bills and certificates of deposit.
Preservation of capital is additionally referred to as capital preservation.
Understanding Preservation of Capital
Investors hold their funds in different types of investments as per their investment objectives. An investor's objective or portfolio strategy is dictated by a number of factors, including age, investment experience, family responsibilities, education, annual income, etc.
These factors typically point out how risk-averse an investor is. Common investment objectives include current income, growth, and capital preservation.
Risk Tolerance and Investment Objectives
The current income strategy focuses on investing in securities that can create returns rapidly. These include securities, for example, high-yield bonds and high dividend-paying stocks. The growth strategy involves finding stocks that emphasize capital appreciation with least consideration for current income.
Growth investors will tolerate more risk and will invest in growth stocks that have high price-earnings (P/E) ratios. Another common type of investment objective for a portfolio is capital preservation.
Securities that are used for the preservation of capital have little to no risk and, in effect, smaller returns compared to current income and growth strategies. Preservation of capital is a priority for retirees and those approaching retirement, since they might be relying on their investments to generate income to cover their everyday costs.
These types of investors have limited time to recoup losses on the off chance that markets experience a downdraft and give up any potential for high earnings in return for the security of existing capital. Since retirees need to ensure that they don't outlive their retirement savings, they typically opt for investments with insignificant risk like U.S. Treasury securities, high yield savings accounts, money market accounts, and bank certificates of deposit (CDs).
A majority of investment vehicles used by investors focused on capital preservation are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. In some, however not all instances, these investors may just be investing their money for the short-term.
Drawbacks
A major drawback of the capital preservation strategy is the slippery effect of inflation on the rate of return from "safe" investments over prolonged periods of time. While inflation might not have a critical impact on returns in the short term, over time, it can substantially erode the real value of an investment.
For example, a modest 3% annual inflation rate can slice the real or inflation-adjusted value of an investment by half in 24 years. The amount that you have is preserved yet, in some cases, the interest you earn on a savings account is unlikely to increase enough in value to offset the slow loss of purchasing power that is a result of even moderate inflation. As a result, in "real" terms, you could lose value, even however you have the same amount of cash.
Hence, investors using the capital appreciation strategy are better off investing in inflation-adjusted investments, like Treasury Inflation-Protected Securities (TIPS), which are issued by the U.S. government.
Highlights
- A major drawback of the capital preservation strategy is inflation's effect on return rates from "safe" investments over prolonged periods.
- Preservation of capital is a conservative investment strategy where the primary goal is to preserve capital and prevent loss in a portfolio.
- Capital preservation strategies necessitate investing in the safest short-term instruments, for example, Treasury bills and certificates of deposit.
