Understanding the Role of Capital Preservation in Investments
Capital preservation is a term used in the investment industry to describe a couple of specific financial objectives. Preservation is protecting the monetary value of an asset.
Sometimes—but less often—capital preservation is taken to mean protecting the inflation-adjusted purchasing power of the asset. This protection is done so that a given pile of money can still buy the same quantity of goods and services by the end of the holding period.
Only after the first or second condition is satisfied does the portfolio owner or manager look to earning an actual, real return on the position.
Learn more about capital preservation and how it works.
What Is Capital Preservation?
Capital preservation refers to the fact that some piles of money are not designed to grow larger. If they do, that's the icing on the cake, but it isn't why you've set them aside. It's not the reason they exist.
Instead, these funds have been saved solely to be there when you need to reach for them. At some point, you do plan on spending the cash. Often, this is necessary because you are approaching, or currently enjoying, retirement. The money will be used to pay your bills, cover your prescriptions, keep the heat on in the winter, and go out to dinner every once in a while. However, with younger investors, the funds are commonly earmarked for a real estate down payment.
How Capital Preservation Works
The reason it's important to indicate when a particular pile of cash has a capital preservation objective is that the act of preservation will severely restrict which investments are a suitable place to park your money.
Real-world experience illustrates that a diversified collection of blue-chip stocks, held in a tax-efficient, low-cost way, will typically outperform all other asset classes. This result assumes you have a long enough time horizon and your initial purchase price was reasonable and not overvalued.
Stocks aren't appropriate for someone who has a capital preservation objective, though. This is because these securities can experience fluctuations in value. Likewise, bonds are often thought to be "safe" for preservation purposes. However, if you introduce a long bond duration, you could see swings in value as large, if not larger, than the stock market.
Key Considerations for Preservation
The key consideration when selecting assets for capital preservation is volatility. Volatility is how much given securities or accounts fluctuate in value. This value is expressed as a percentage of the original cost basis.
The classic capital preservation choices in the United States include FDIC insured checking accounts, savings accounts, money market accounts (not money market funds—those are different), and certificates of deposit (CDs). You can also add very short-term Treasury bills—parked directly with the United States Treasury through a TreasuryDirect account—into this category.
In all cases, an investor should be able to preserve the nominal value of their cash, minus any bank fees or expenses.
Other options include actual bills stuffed under a mattress, in a coffee can that you bury in the backyard, or put away in a safe deposit box, though these all come with risks of their own.
United States savings bonds can be a good choice for an investor with a slightly longer time-horizon and no need for current cash income.
Selecting Appropriate Assets
Roughly once every generation, new financial securities come into vogue on Wall Street and people use it as a cash equivalent for their capital preservation needs. Then, a recession or some other crisis inevitably hits, and it becomes all too apparent that safety was an illusion.
This happened during the Great Recession of 2008 and 2009 with something called auction-rate securities. People had been treating these investments as if they were identical to cash in the bank. They weren't, and some folks lost millions of dollars almost instantly when they were unable to find a buyer for their paper.
As a general rule, it's helpful to remember that if capital preservation is truly necessary, accepting a 0% rate of return, or a slightly negative rate of return after inflation, is preferable to putting money you can't afford to lose at risk.
- Capital preservation is keeping your funds in low- or no-risk vehicles so you don't lose your money.
- Stocks are not considered appropriate for capital preservation due to fluctuations in value.
- Volatility is an important consideration when deciding on what vehicle to use for capital preservation.
- Be wary of new securities that seem to promise security. Instead, look at established options like carefully chosen bonds, savings accounts, CDs, money market accounts, and short-term Treasury bills.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.