Preservation of Capital: Strategies, Risks, and Drawbacks

What Is Preservation of Capital?

Preservation of capital is a conservative investment strategy focused on protecting principal and avoiding losses. It usually involves low-risk investments like Treasury bills and certificates of deposit, making it suitable for retirees and risk-averse investors. While it offers security, returns are modest and can be eroded by inflation over time.

How Preservation of Capital Works

Investors hold their funds in various types of investments according to 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.

Balancing Risk Tolerance With Investment Goals

The current income strategy involves investing in assets that generate quick returns, like high-yield bonds and high dividend-paying stocks. The growth strategy involves finding stocks that emphasize capital appreciation with minimum consideration for current income.

Growth investors are willing to 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. Retirees and those nearing retirement prioritize capital preservation since they rely on investments for living expenses.

These investors have little time to recover from market declines and prioritize capital safety over high earnings. Since retirees want to ensure that they don’t outlive their retirement savings, they usually 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).

Most investment vehicles for capital preservation are FDIC-insured up to $250,000. Some investors choose these for short-term investments.

Potential Drawbacks of Capital Preservation

A major drawback of the capital preservation strategy is the insidious effect of inflation on the rate of return from “safe” investments over prolonged periods of time. While inflation may not have a significant 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 slash the real or inflation-adjusted value of an investment by 50% in 24 years. Your savings remain intact, but interest often won’t grow enough to counteract the loss of purchasing power from moderate inflation. As a result, in “real” terms, you could lose value, even though you have the same amount of cash.

For this reason, investors utilizing the capital appreciation strategy are better off investing in inflation-adjusted investments, such as Treasury Inflation-Protected Securities (TIPS), which are issued by the U.S. government.

The Bottom Line

Capital preservation aims to protect invested principal through conservative assets like Treasury bills and certificates of deposit. It’s especially valuable for retirees or those nearing retirement who prioritize stability over growth.

However, inflation can erode real returns, making inflation-protected options like TIPS worth considering. Investors should align this strategy with their risk tolerance and long-term financial goals.