Understanding the Role of Capital Preservation in Investments

Illustration of men in suits holding umbrellas over their investment piggy banks to preserve their capital.

 Diane555 / Getty Images

Capital preservation is a term used in the investment industry to describe a couple of specific financial objectives. Preservation is protecting the absolute monetary value of an asset as measured in nominal currency. 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 once the first, or in some cases, the second condition is satisfied, does the portfolio owner or manager look to earning an actual, real return on the position.

The Plain English Version

That may sound very technical and difficult to understand. It isn't. In plain English, capital preservation is a code word meant to recognize 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 is 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 medical 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.

Certain Assets Are More Appropriate for Capital Preservation Than Others

The reason it is important to indicate when a particular pile of cash has a capital preservation objective is that the act of preservation will severely restrict the universe of intelligent assets—or investments—into which you can park the money.

Academic evidence and real-world experience illustrate that a diversified collection of blue-chip stocks, held in a tax-efficient, low-cost way, will utterly crush all other asset classes. This result is provided you have a long enough time horizon, and your initial purchase price was rational relative to the underlying discounted earnings and book value of the investment.

Stocks are never appropriate for someone who has a capital preservation objective. 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 Investment Considerations for Preservation

Due to the primary objective of capital preservation, the key consideration when selecting individual assets that comply with the needs of the portfolio owner following such a policy focus mainly on 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 that is under the applicable limits should be able to preserve the nominal value of their cash, minus any bank fees or expenses.

Other options include actual greenbacks—banknotes—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. For an investor with a slightly longer time-horizon and no need for current cash income, United States savings bonds can also be a good choice.

The Dangers of Selecting Inappropriate Assets

Roughly once every generation, new financial securities come into vogue on Wall Street, and people seem to 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 is helpful to remember that if capital preservation is truly necessary, even accepting a 0% rate of return, or slightly negative rate of return after inflation, is preferable to putting the money you cannot afford to lose at risk. Don't "reach for yield." You won't like the results.

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.