Capital preservation is an investment approach, whose purpose is to avoid losses. It is fairly common among retirees, or those of us who are close to retirement. It is characterized by a short-term investment horizon, and risk aversion. Although it is often used by retirees, or people that are about to retire, some risk averse investors also adopt it. There are also some investors with more risk tolerance, that might choose to have a part of their portfolio focused on capital preservation.
Why invest for capital preservation?
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 have a preference for capital preservation over capital appreciation. This is closely related to 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. That is why it is so important to avoid losses at all costs.
What are the best capital preservation investments?
There are a few options when it comes to investing for capital preservation. The idea that you have to limit yourself to a few investments because you want to preserve capital is incorrect. There are several assets that might be adequate for capital preservation.
Bonds tend to be among the safest investments. They provide investors with a fixed interest, and you are essentially lending your money to corporations or governments.
Treasuries in fact 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 with treasuries is their low yield. There is also the risk of inflation. If inflation 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 you with 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. Although 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 a great 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 more risky, and 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. More 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:
Utilities stocks are among the most defensive stocks you can invest in. Anything from 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 that you will most likely not lose your principal.
There are also a number of 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 are able to make considerable recurring revenues. Telecommunication stocks are also known for paying consistent and growing dividends.
The healthcare sector is another great option. Most of the stocks in this are also highly defensive, and tend to be less volatile.
Lastly, consumer staple stocks are also among the most defensive, and can be a great option to boost your returns.
It is important to keep in mind that when dealing with stocks every company is different. For that reason these are just general considerations on some of the sectors that are more defensive. If you look for stocks in these sectors, you might find some great fits for your capital preservation portfolio.
Although capital preservation should be your main focus as you get older, we advocate that 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, otherwise it depreciates overtime. 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.
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