When selecting assets for a portfolio, it’s important to consider an investor’s risk tolerance. While some investors are willing to take on more risk to achieve a greater return, others may forgo any risk to preserve their capital. Capital preservation is what it sounds like – an investment strategy that preserves your money. The best investment strategies to make sure you don’t lose any money are going to be low-growth assets that are protected, such as CDs or savings bonds. Work with a financial advisor to put together a financial plan and choose investments that are going to work with your overall goals.
What is Capital Preservation?
Capital preservation is an investment strategy that aims to preserve capital and prevent loss of a portfolio. When using this investment strategy, investors opt for safe assets such as Treasury bills and certificates of deposits (CDs). Investors who use this strategy tend to be risk-averse and have a short time horizon. Often, retirees or those approaching retirement will use this investment strategy to preserve funds to support their lifestyle after they stop working.
Capital preservation investors generally have a limited amount of time to recuperate their losses from a market dip or recession. They choose to give up potential returns in exchange for the security of their current savings. Since many retirees don’t want to outlive their retirement savings, they choose investments that are risk-averse.
Capital Preservation Investments
When selecting assets for a capital preservation portfolio, it’s most important to conform to the investor’s time horizon. Generally, investors who choose capital preservation prefer to focus on market volatility, which is the amount a security or asset fluctuates in value.
Investors who prefer capital preservation methods often select investments, like checking accounts, savings accounts and money market funds insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. These are assets that are immediately available.
If capital preservation is the priority but money will not be needed for a few months, then money market accounts, CDs – both FDIC insured – and short-term Treasury bills are often chosen. The U.S. Treasury also sells Inflation-Protected Securities, which are assets that offer both capital preservation and immunity from inflation.
Finally, assuming money will not be needed for a few years, capital preservation can also be achieved with short-term municipal bonds, short-term corporate bonds, U.S. savings bonds and U.S. agency bonds.
Growth Investing vs. Capital Preservation
The investment strategy for many is that with a focus on growth. Investors with a growth mindset are looking to increase their total capital size or to create returns quickly. This type of investment approach emphasizes capital appreciation and investors can tolerate more risk in order to achieve these goals.
This is, of course, contrary to a capital preservation approach. The investments being looked at by those wanting to implement a capital preservation approach have little to no risk at all. This often creates much smaller returns than a growth investing strategy would, but it’s safer. Investors choosing a capital preservation approach typically can’t afford the time it would take to recoup any losses from high-risk securities if markets take a turn for the worse for a period of time.
Disadvantages of Capital Preservation
The biggest disadvantage of using a capital preservation strategy is inflation. While fixed-income investments are generally seen as safe and promise foreseeable returns, inflation can wipe out those returns. That’s because the interest rate paid by fixed-income investments is usually a nominal interest rate. This means the rate doesn’t account for inflation. A fixed-income investment’s real interest rate is the nominal rate minus the rate of inflation.
So, if you have a treasury note with a nominal rate of 3% and inflation rises to 2%, the T-note’s real interest rate will be just 1%. Or, perhaps inflation rose to 5%. In this case, your real interest rate would be negative 2%. Essentially, this means that your investment would lose value.
Since inflation can have a big impact on the value of your portfolio, capital preservation is only recommended as a short-term strategy. As a general rule, if you cannot afford to lose any of your retirement savings, it’s acceptable to invest in assets that may yield a 0% or even slightly negative return.
The Bottom Line
The most recommended method of selecting an investment strategy would be to prioritize your time horizon and risk tolerance. If the idea of losing any of your retirement savings scares you, you may want to use a capital preservation strategy. On the other hand, if you believe in trying to reach the highest return possible, even if it means you could lose money, you may want to consider a more risky investment method.
Keep in mind, that your risk tolerance may change over time. It’s okay to select a more risky investment mix while you save for retirement. Once you are in the final stages of retirement preparation, you can change your asset allocation. Make sure to consult with your financial advisor for guidance and support when selecting your investment mix. Your financial advisor can help you choose the best asset mix that matches your goals and time horizon.
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