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What is capital preservation?
It is a defensive investment approach aimed at preventing or minimizing the loss of your original capital.
This strategy is especially relevant for risk-averse investors or those reaching retirement, for whom a financial setback can be hard to recuperate.
In this guide we will explore capital preservation and provide you insights into maintaining the value of your investments, particularly in times of economic uncertainty.
We will also address how to consider factors like inflation that eat away at your investments purchasing power.
Capital preservation refers to an investment approach that focuses on preserving the initial capital (investment amount) and minimizing any potential losses.
It prioritizes security over high returns, making it a preferred strategy for many investors. One of its main challenges is inflation, which can decrease the actual value of investments.
Investors who prioritize capital preservation typically opt for conservative options such as bonds, cash, and money market funds in order to maintain stability. Government-insured products like FDIC-insured offerings or Treasury bills may also be viable choices.
This investment strategy is particularly suitable for individuals at retirement age who are risk-averse and seek to protect their principal amount while using their investments for covering living expenses.
Click here to schedule a free consultation with our fee only fiduciary financial planning team.
The core principles of capital preservation include adopting a conservative investment strategy focused on protecting and reducing potential losses within a portfolio.
It involves evaluating risks and volatility levels in order to stabilize the dollar value of the investment.
This should be done at two levels - the global level and the detail level.
At the global level, we manage risk by:
At the detail level we manage risk by:
While these are sound portfolio management techniques that should be applied in all circumstances, the method of application will differ depending on your investment strategy and goals.
There are 3 predominant investing strategies:
The objective of a capital appreciation strategy is to buy an investment at a low price and sell it at a future date for a higher price.
In this strategy you must SELL the investment in order to regain access to your underlying investment dollars.
The focus is on buying higher risk assets with greater opportunity for growth in order to capitalize on the increase in price over time.
The objective of a portfolio income strategy is to produce "passive" income generated with minimal risk WITHOUT SELLING the underlying investments.
Usually, you will have to give up some opportunity for growth in the form of price appreciation in order to generate the portfolio income.
The objective of capital preservation is to protect your original investment money while at least matching the rate of inflation so that you do not lose purchasing power over time.
Investors should consider transitioning to a capital preservation plan when approaching retirement age or shifting their focus from growing their portfolio to safeguarding its value against potential losses.
Examples of common tools used for achieving effective capital preservations include FDIC insured checking accounts, savings accounts, Treasury bills, certificates of deposit, and high-quality bonds. These financial instruments are specifically designed to reduce the risks associated with investments.
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Capital preservation is a favored approach for investors who are nearing retirement or have a low risk tolerance.
Its main goal is to safeguard the initial investment and minimize the chances of losing the principal.
Retirees, in particular, need to prioritize capital preservation due to their short time horizons which limit their ability to recover from market losses.
Capital preservation investment strategies are particularly useful to protect against sequence of returns risk.
You can see our guides Navigating the Retirement Risk Zone and Sequence of Returns Risk here.
Managed properly, a retirement portfolio constructed with a capital preservation strategy should be able to outpace inflation and maintain the purchasing power of your capital over time.
Building a successful capital preservation portfolio requires deliberate consideration of low-risk assets, diversification, and risk management techniques.
The ultimate goal is to minimize the impact of market fluctuations and provide a safety net for your capital.
We use the following checklist when constructing a capital preservation portfolio:
1) Ignore Asset Allocation (you can read our longer opinion and guide to asset allocation here)
2) Identify your "Required Portfolio Income"
3) Identify your financial plan required rate of return
4) Construct a portfolio "1st draft" where no single position is larger than 5% of the portfolio value
5) If using Exchange Traded Funds, verify that there is not significant overlap in investment holdings between the funds you select
6) Use a tool such as portfolio visualizer to back test your model over at least a 10 year period.
7) Understand investment terms such as "Beta", "Market Correlation", "Worst Year", "Max Drawdown", and Rate of Return, and compare your model portfolio against other alternatives.
8) Once satisfied with your model portfolio's measures of beta, market correlation, worst year, and rate of return, execute your portfolio
9) Monitor your performance in both offensive and defensive statistics quarterly.
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It's important to understand that asset classes alone are not a sufficient guide about the level of risk or stability of an investment.
If you haven't already read or watched our guide to asset allocations, we encourage you to read or watch here.
Bonds are typically thought to be conservative (preserving capital), and stocks thought to be risky.
However, some bonds function more like stocks, while some stocks function more like bonds.
Bonds that function like stocks would be Exchange traded funds that are long term bond funds such as TLT (10+ year US Bonds) or EDV (20+ year US Bonds).
Bonds as an asset class are "conservative", however a fund such as TLT or EDV can have HUGE price swings as interest rates change.
Conversely, stocks that function more like bonds would include defensive (value) stocks such as VZ, T, PG, or KO.
These stocks will not have "wild" swings in price and instead pay their shareholders a dividend as an incentive to hold the position since the holder will likely not see significant price appreciation over time.
With this in mind, throw asset classes out the door and instead focus on the more minute categories of investments that ACTUALLY preserve capital when constructing your capital preservation portfolio.
The types of investments we favor in capital preservation portfolio's include:
1) Value Stocks
2) Consumer Staple stocks
3) Health Care stocks
4) Money Market accounts
5) Short term US Government bonds (less than 5 years in duration)
6) Certificates of Deposit
7) High Yield Savings Accounts
Fixed income investments are types of assets or securities that provide a predetermined amount of interest income, also known as "Bonds".
A bond is essentially a loan you give to either a government or a company.
The entity promises to pay you back the ENTIRE original investment after a predetermined amount of time, and along the way will pay a stated interest rate in return for your patience.
The main purpose of fixed-income investments is to generate steady income for investors through regular payments until their maturity date when the initial investment is returned.
These types of investments come with various risks including credit risk, spread risk, downgrade risk, liquidity risk, inflationary risk and interest rate fluctuations which can impact the value and stability of one’s capital.
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Risk tolerance refers to an investor’s ability to handle the potential risks associated with investing and the potential fluctuations in investment value.
Experts suggest that as individuals age, they should gradually decrease their risk tolerance. This means being more conservative when investing money needed within a shorter time frame.
Protecting principal becomes increasingly important for those nearing retirement who may face market volatility which can threaten their financial stability if they will be relying on their investment assets for income.
Investing for shorter periods of time may require a cautious approach to safeguard capital, while longer investment horizons allow room for more aggressive strategies that could yield higher returns.
A common capital preservation strategy that illustrates this is the Retirement Bucket Strategy, also known as the 3 Bucket Strategy.
The timeframe in which investments are made affects the use of capital preservation techniques by prioritizing protection of the initial amount invested instead of chasing after high profits, resulting in a more conservative asset allocation.
Capital preservation methods can also benefit long-term investors through minimizing losses during market downturns.
The strategy chosen varies based on the desired time horizon as short-term investing calls for a greater portion being allocated towards safer, more liquid, more stable investments.
On the other hand, medium- or long-term investing requires having a balanced spread among a wider range of investments more capital appreciation potential.
Click here to schedule a free consultation with our fee only fiduciary financial planning team.
Investments focused on protecting capital can be affected by the gradual devaluation caused by inflation.
An improperly executed capital preservation strategy may not outpace the reduction in purchasing power caused by inflation.
As such, we advise most individual investors to seek out the help of a fee only fiduciary financial planner who can help educate and construct this type of portfolio strategy.
Inflation is the erosion of purchasing power over time because of the increasing cost to produce and sell goods.
The reason we invest for retirement AT ALL is to maintain our saved dollars purchasing power.
When interest rates are exceedingly low, as they have been from 2009-2022, interest bearing investments (fixed income investments) may not outpace inflation and result in negative real rates of return, dissuading investors from using a capital preservation strategy.
Click here to schedule a free consultation with our fee only fiduciary financial planning team.
The relationship between bonds and interest rates is inverse. As interest rates go up, bond prices decline, while decreasing interest rates lead to higher bond prices. This is because rising interest rates make the fixed rate on existing bonds less desirable compared to new ones issued at a higher rate. As a result, there is reduced demand for current bonds leading to their price decrease.
On the other hand, lower interest rates typically cause an increase in bond prices due to the more attractive nature of preexisting high-interest-rate bonds resulting in greater demand and subsequent increases in value.
Seek guidance from a fee only fiduciary financial advisor who leads with financial planning when considering how to best position your capital preservation investments:
Click here to schedule a free consultation with our fee only fiduciary financial planning team.
Just as reading a book can shortcut your timeline to expertise on a subject, so too can hiring a professional.
Remember - when you try to learn how to invest your retirement savings on your own, you are taking a gamble with your own money.
You are essentially saying that you will pay less in the form of making mistakes on your own then you would pay a financial planner or financial advisor to shortcut your mistakes.
When it comes to preserving capital or even investing in growth strategies, it's critical to first begin by constructing a detailed financial plan, a road map that tells you how much to save, what rate of return you need, how to minimize taxes, and ultimately how to construct your investment portfolio.
Click here to schedule a free consultation with our fee only fiduciary financial planning team.
In summary, maintaining capital is a crucial tactic for all investors, especially those who are approaching retirement or have a conservative attitude towards risk. This strategy involves carefully choosing low-risk investments, creating a diverse portfolio, understanding personal risk tolerance levels and managing the effects of inflation and interest rates. Although it may seem daunting at first glance, always remember that seeking expert advice can guide you through these challenges. Safeguarding your wealth requires patience, wisdom and strategic planning over time rather than quick fixes - with the right approach, you can protect your assets and achieve desired financial objectives.
One way to preserve capital is by investing in secure options provided by the government such as FDIC-insured checking and savings accounts, certificates of deposit, and U.S. Treasury bills. These types of investments are considered low-risk and aim to safeguard your initial capital.
Capital preservation is important because it shields investors from market volatility and is commonly used by individuals with a fixed income or retirees to secure their living expenses in the future. The focus is on protecting the investment rather than generating significant profits.
Capital preservation is the concept of protecting the money you’ve invested, to ensure that you don’t end up in a scenario where not investing would have been the better choice. This is a fundamental principle in investing.
Investments in capital preservation funds aim to safeguard the value of your investment, but there is no assurance or guarantee. These funds are not backed by government agencies and carry a certain level of risk for investors looking to protect their capital.
The main goal of capital preservation is to prioritize the security and protection of the initial investment amount. It emphasizes safeguarding the invested capital rather than striving for significant profits.
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