Is it Okay to be a Conservative Investor?

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The investing public has been conditioned to believe that there exists a general rule of thumb indicating those who are younger, more savvy, or fans of skydiving without a parachute should always utilize a more aggressive portfolio allocation.  The logic behind the notion is that youth allows more time to recover from losses, experience helps explain away losses, and adrenaline junkies will grow bored with anything but the most severe losses.

These things may or may not be true, but even if they are legitimate excuses for aggressive investing, understanding how the intricate web of math, emotions, and time works together may lead to a more accurate assessment of the risk profile most suitable for your circumstances.

First, we must clearly define what “risk” actually represents, as the mainstream interpretation may not be the most accurate.  Many believe the word to mean, “How much could I lose?”  While loss potential is a major consideration, I believe a more accurate question is, “How much could I lose before making a really bad decision?”

If you want to invest in securities, you must accept the reality that your account value will not always move in an upward trajectory.  Occasional losses are simply a part of the process and, occasionally, those losses may be substantial.  The thing you must consider is how much drawdown you can psychologically tolerate before feeling compelled to sell, thus realizing damaging losses and lowering your odds of participating the typically lucrative early stages of economic recoveries.

There are many ways your advisor can help you determine your true risk tolerance, but we will skip that discussion in this post.  The subject I want to focus on from here is the true cost of being too aggressive.  As you will soon discover, it is, in my opinion, not only okay to be a conservative investor, but often advisable … no matter your age, experience, or penchant for white-knuckled experiences.

The first useful bit of information I want to reveal is what some consider a dark secret of the professional investing industry:  The average annual performance of the average investor.  According to the research company, Dalbar, the investing public could use some serious help.1

For the trailing 10-year period ending on 12/31/16, the S&P 500 earned 6.95% per year, which is almost double the average investor’s return of 3.64% annually over the same span.  Lest we assume that was just a bad decade for stock-pickers, the trailing 30-year comparison is even worse. Over that time, the S&P 500 posted slightly more than 10% per year on average, while the average equity investor came in just under 4.0% annually.

Bond investors didn’t have any room to brag either.  Looking back ten years from the end of 2016, the Bloomberg Barclays Aggregate Bond Index averaged an annual growth rate of 3.97%.  The average fixed-income fund investor, on the other hand, raked in a paltry 0.40% per year.

But here’s the kicker:  Dalbar defines the “average investor” as everyone who held a mutual fund portfolio over the sample period, regardless of whether they worked with professional advisor or not.

The lesson here?  If you, or you and your advisor, decide to invest in securities, you need to be certain you will be able to weather all the ups and downs that come along with the strategy.  Arriving at a market trough, only to discover you are much less aggressive than you thought you were at the peak (a characteristic shared by nearly every investor) is a recipe for disaster.

To further assuage those with a more conservative bent, here is some math to illustrate the true cost of experiencing deep market losses over time.

Let’s look at three hypothetical investors.  Each will start with an initial investment of $100,000 and will stay in their respective portfolios, regardless of annual performance, for the duration of ten years.

Our first investor, Terry, is what we would call “ultra-conservative,” using only guaranteed fixed-income assets like CDs and US Treasuries.  His annual return will fluctuate slightly but will never be negative in any given year.

Year Year-end Balance Annual Return
1  $        102,300 2.30%
2  $        104,448 2.10%
3  $        106,433 1.90%
4  $        108,987 2.40%
5  $        112,039 2.80%
6  $        115,512 3.10%
7  $        118,977 3.00%
8  $        122,249 2.75%
9  $        125,306 2.50%
10  $        128,376 2.45%

At the end of the ten years, after earning an average annual return of 2.53%, Terry will have $128,376 in his account and no ulcers to speak of, thanks to his steady, predictable performance.

The next investor, Kristine, is slightly less risk-averse, opting for a moderate portfolio containing a blend of equities and bonds.  Unlike Terry, she will experience some losses, but none will be as severe as a 100% stock allocation.

Year Year-end Balance Annual Return
1  $        106,400 6.40%
2  $        114,540 7.65%
3  $        119,465 4.30%
4  $        110,326 -7.65%
5  $          97,859 -11.30%
6  $        106,666 9.00%
7  $        111,840 4.85%
8  $        117,599 5.15%
9  $        125,302 6.55%
10  $        130,314 4.00%

Notice that, compared to Terry’s performance, Kristine’s worst positive year was better than Terry’s best positive year.  However, thanks to those two negative years, Kristine only netted $1939 more, or 3.65% better cumulative performance, over the whole ten years.  And this is assuming she didn’t panic and sell out during the downturn.

For our last investor, Carl, will represent the most aggressive, thus most volatile, of the three portfolios.

Year Year-end Balance Annual Return
1  $  107,950 7.95%
2  $  118,043 9.35%
3  $  125,067 5.95%
4  $  111,497 -10.85%
5  $    89,811 -19.45%
6  $    98,972 10.20%
7  $  104,663 5.75%
8  $  111,937 6.95%
9  $  119,884 7.10%
10  $  127,017 5.95%

Despite that fact that every positive year outperformed Kristine’s account for the same period, he also suffered greater losses in the two down years, causing him to not only win the ulcer award, but wind up with the lowest balance of the three.  Now, here is where the math gets wild … Carl’s average annual performance was exactly the same as Kristine’s, coming in at 2.90%.  Such is the destructive power of deep losses, even for a couple of years.

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