Principal Protection

"Principal protection" is a term one hears a lot these days as investors look for safe places to stash their money during the current downturn. Investments like money market funds and individual Treasury bonds offer principal protection. It's easy to see why the idea of not being at risk of losing principal is very appealing. Unfortunately, investors get a little carried away with this idea.

To begin with, people put too much emphasis on not losing money. 0% is one point along a spectrum of possible returns. It's a little bit worse than +1% and a little bit better than -1%. People who make principle protection the be-all and end-all of their investment strategy are effectively saying that there is a very sharp "cliff" between 0% and -1% and that by all means they do not want to fall off that cliff. This imaginary cliff can distort one's comparison of different investment options.

Perhaps the more critical point, though, is that investments like money market funds and individual bonds do not offer principal protection in the only currency that really matters; i.e., purchasing power. Due to inflation, the dollars you get out when a bond matures may have significantly less purchasing power than the dollars you put in when you purchased that bond. So you really do not get principal protection in any sense that really matters.

This mistaken attraction to the siren song of principal protection might be considered harmless, but I think it has been used, or abused, by financial advisors to steer investors towards one particular investment choice that often does not make sense for them; namely, towards individual bonds rather than bond mutual funds. One of the main selling points touted for individual bonds is, in fact, principal protection, which a bond mutual fund cannot offer. However, in my opinion, a bond mutual fund is generally a better choice for the individual investor. A bond mutual fund will offer better diversification, better liquidity and lower costs. The last advantage may not be understood by many investors, because the costs in buying and selling individual bonds are often hidden to the investor. They may be embedded in bid/ask spreads, for example.