What is capital preservation?
Capital preservation is an investment approach that has the primary goal of avoiding losses while generating returns. Investors that are more concerned with preserving their capital than generating large returns often take this approach, as a way of preserving wealth, instead of accumulating it.
This is a fairly common investment strategy among retirees or individuals that are approaching retirement. While they are still trying to generate returns with their capital, they are much more concerned with avoiding losses to make sure they have enough funds for when they stop working.
How capital preservation works
To better understand how capital preservation works, it is crucial to understand the characteristics that define it. Here are some of the most important aspects of capital preservation:
- Short-term investment horizon
- Risk aversion
- Safe investments
- Low-risk tolerance
- Diversified portoflio
Short-term investment horizon
Investors that follow a capital preservation investment strategy often have a short-term investment horizon. This means that they will look for stable and less volatile investments that guarantee that they do not lose their principal. An example of this would be short-maturity treasuries, or corporate bonds, as well as CDs.
Additionally, they may also invest in stocks, but they usually prefer dividend stocks, which are stable and well-established companies whose stock prices are not volatile.
Obviously, if your main goal is to preserve capital, you will be risk averse, and this is another common characteristic of investors following this approach. In order to avoid losses, you need to avoid taking risks, and therefore to preserve capital, you want to avoid risks at all costs. This means sticking with plain and boring safe investments that are guaranteed to work.
As we mentioned, safe investments are a crucial part of investing for capital preservation. Investors looking to preserve their capital know that there are only a few investment options that can actually generate guaranteed returns without risk and without constantly worrying whether or not their investments will lose value.
When investing for capital preservation, your risk tolerance is usually very low. What this means is that you will not be able to handle losses and constant volatility that may unsettle you. For these reasons, investors with a capital preservation approach have a very low-risk tolerance.
Finally, diversifying your investment portfolio is another simple way of reducing risk, and capital preservation investors are well aware of this. For this reason, they often diversify their portfolio a lot, with different assets, so that they can avoid losing any money.
Capital preservation portfolio example
Let’s consider an investor that is looking to preserve their capital and what exactly his or her portfolio would look like. Here is a simple example of what a capital preservation portfolio would look like:
- 20% in CDs
- 20% in treasuries
- 20% in municipal bonds
- 20% in dividend-paying defensive stocks
- 20% in corporate bonds
Why capital preservation is important
There are two main reasons that can explain why your main goal as an investor could be capital preservation. The first is that when we reach a certain age, close to retirement, we want to make sure that we preserve our capital. For that reason, you might want to avoid riskier investments and reduce your risk exposure.
Even if you are younger, you might want to prefer capital preservation over capital appreciation. This depends on your risk appetite and how you want to conduct your investments. For that reason, you might want to make sure you preserve your capital. Risk aversion is common among some investors, and it is important. Warren Buffett’s view on it is pretty simple.
"Rule Number One: Never Lose Money. Rule Number Two: Never Forget Rule Number One"
- Warren Buffett
It is important to remember that when you lose money, you limit your ability to compound your investments. This is what Warren Buffett is referring to, and why it is so essential to avoid losses at all costs.
Best capital preservation investments
There are a few options when it comes to investing in capital preservation. The idea that you have to limit yourself to a few investments because you want to preserve capital is incorrect. Here are the best options when it comes to investing for capital preservation:
Bonds tend to be among the safest investments. They provide investors with a fixed interest, and you essentially lend your money to corporations or governments.
Treasuries are nearly risk-free investments that provide a modest yield. Since they are backed by the government, the risk of default is extremely low. The main disadvantage of treasuries is their low yield. There is also the risk of inflation, and if the inflation rate is higher than the coupon on the bond, you are essentially losing money.
Treasury inflation-protected securities (TIPS)
Treasury inflation-protected securities, which are commonly referred to as TIPS, are a good option to fight off inflation. As we have seen lately, inflation has been picking up throughout the world. For those investors that are concerned about inflation, TIPS are a great investment option.
Municipal bonds are another great risk-free option. They allow you to lend money to different public entities while providing a good yield. We would also advise you to look for municipal bond ETFs that allow you to buy a basket of municipal bonds. Instead of buying individual bonds
Corporate bonds will tend to have a higher yield. As with most things in investment, the higher the yield, the higher the risk. However, some corporate bonds tend to be great options to earn interest on some of your money. The high-yield corporate bonds offer considerably more risk. Usually referred to as junk bonds, they usually have a higher interest and a higher probability of default.
We would advise you to look for bond ETFs instead of buying individual bonds. The bond ETFs are managed carefully and offer enough diversification in case something goes wrong.
Annuities are also a great investment vehicle for capital preservation. They offer a steady stream of cash flows and are among the most common investment option for retirees.
Cash deposits (CDs)
Cash deposits are also a great way of investing with little to no risk. Banks usually offer CDs to their clients, and it is an excellent way of keeping some cash at hand and also earning interest on it. Make sure you compare the interest that different banks offer to make sure you get the highest yield.
Some investors looking for capital preservation strategies will often steer away from stocks altogether. Stocks tend to be riskier and more volatile. However, there are some stocks and sectors that tend to be highly defensive.
Stocks can ensure that you get a higher yield on your capital while also avoiding risk. One of the most common strategies used by some risk-averse investors is to focus on dividend-paying stocks. Particularly in growth dividend stocks. This can provide you with a higher yield than most bonds, and they tend to be less volatile stocks.
There are also some sectors and specific stocks that tend to be defensive. Here are some options:
Utility stocks are among the most defensive stocks you can invest in. Anything from the electricity supply, water supply, wastewater, and waste management are always great options for retirees. They are steady dividend payers, and although the growth is minimal, it ensures you will likely not lose your principal.
There are also several sectors that are usually considered defensive. Some of the stocks in these sectors carry significantly more risk than utilities, but they can also give you a higher return.
The telecommunication sector is known for being defensive. Due to the nature of the services and products they provide, they can make considerable recurring revenues. Telecommunication stocks are also known for paying consistent and growing dividends.
The healthcare sector is another great option since most of the stocks are also highly defensive and tend to be less volatile.
Lastly, consumer staple stocks are among the most defensive and can be a great option to boost your returns.
It is important to remember that when dealing with stocks, every company is different. Therefore, these are just general considerations for some more defensive sectors. If you look for stocks in these sectors, you might find great stocks to add to your capital preservation portfolio.
What is the safest investment to preserve capital?
The safest investment to preserve capital is undoubtedly treasuries because the default risk is nearly zero. When you invest in treasuries, you are lending money to the government, which in turn pays you interest for it. This is a nearly risk-free investment with guaranteed principal and returns.
Capital preservation vs. growth vs. income
Understanding the difference between the 3 major types of investment approaches is also necessary if you are trying to build an investment portfolio. While capital preservation’s main goal is to avoid losses, growth investing and income investing focus on totally different aspects.
A growth investing approach has one single goal - capital accumulation. This is often a strategy used by younger investors that have a higher risk tolerance and appetite and are looking to build wealth through their investments. They can handle volatility, and potential short-term losses, in search of their goal to accumulate and compound their capital.
Certain investors are not only focused on accumulating or preserving their capital, instead, but they also focus mainly on generating cash flow from their investments. In theory, income investing can be combined with a capital growth or preservation approach, there is a distinct aspect. Income investors will often focus on either fixed-income or income stocks, more commonly referred to as dividend-paying stocks.
While capital preservation should be your main focus as you get older, part of your portfolio should be invested with the goal of capital preservation. For instance, if you have an emergency fund, it should not be all in cash because it depreciates over time. Instead, you can use part of that emergency fund to dedicate to investments that will preserve that capital.
If you are a risk-averse investor, then capital preservation should be your main goal. There are several investment approaches, like value investing, that allow you to appreciate your capital while also preserving it. There are some stark differences between capital appreciation and capital preservation, but investors should try to combine both in their investments.