Why Investing Conservatively Is Better

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Why Investing Conservatively Is Better

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When doing work with clients, I have several ways to determine the correct allocation they should have to stocks and bonds. More often than not, I find that clients are over allocated to stocks and are therefore taking more risk in their portfolios than is needed. Today, I want to discuss why investing more conservatively is usually better at helping clients meet their financial goals.

 Having a lower allocation to stocks may seem counterintuitive but it would help you reach your goals with less risk. 

When we run simulations for clients, one of the items we check is the impact of the allocation on the success. By reducing the client’s stock allocation, they are usually surprised that their rate of success increases. The reason is twofold, by limiting risk you keep more of what you earn, and you are also more likely to stick to your investment strategy. Our planning model can quantify the effect of keeping more of what you earn, but it can’t quantify the likelihood that a client’s investment strategy will change during the downturn. Therefore, the increase to success is probably even greater than shown in our Monte Carlo simulations!

Defining Goals

When we are determining a client’s rate of success, we are rarely aiming for an infinite amount of money. Instead, we are trying to get the client through their lives while having enough money to meet their spending needs, while also leaving some assets to their heirs. Our goal is a number greater than zero. Some clients have an inheritance goal, say $1,000,000 per child, and this is still much easier to target than “as much money as possible.”

How Much Risk to Take?

Because we are shooting for an actual number, we can determine the minimum rate of return to reliably reach this figure. Any deviation from this rate of return can be defined as “risk.” To reach our goal, we want to stay as close to on track as possible.

Usually, investors don’t view above average returns as risk. Therefore, when stock markets are trending upwards, investors tend to increase their allocation to stocks in order to grab the higher returns. This, increases the percentage of stocks in their portfolio in two ways. Firstly, they are either selling other assets and moving them to stocks or they are simply adding more money to the stock portion of their portfolios. Secondly, the overall value of the stocks are increasing, which in and of itself would increase the percentage of stocks in their portfolio. This often makes investors over allocated to stocks in the latter part of a bull market.

When the downturn comes, those investors will likely experience outsized losses in their portfolios, especially compared to their original expectations. For example, if you started out investing 60% in stocks and the market increases by 100%, you will now have a 75% stock allocation if you did not rebalance. The normal portfolio decline in a bear market is 21% for a 60% stock investor. However, since the stock allocation is now at 75% this investor has an increased decline of 26%.

The takeaway here is to determine the required rate of return to meet your goals. It’s easy to find historical rates of return for stocks and bonds, so with the target rate of return, it should be fairly easy math to come to a portfolio allocation. In my planning process, this is one of the three pieces of the puzzle we use to come to a recommendation on portfolio allocation.

Keeping What You Earn

I would submit that limiting your risk allows you to keep more of what you earn, rather than giving a large portion of it back when the next downturn comes. With that in mind, lower stock allocations through rebalancing may limit the upside, but it also limits the downside and can actually increase terminal portfolio value after a full stock market cycle.

For argument’s sake, please endure my simplified math of investment returns. I have used a 12% rate of return for stocks and zero for bonds. I chose these numbers due to the “Rule of 72” which tells you how long it will take (approximately) for your money to double.

If you invested $10,000 with an original allocation of 60% stocks and 40% bonds, after a 100% increase in stocks over six years, your account will likely have $15,840 in it. If stocks then decline by 35%, you will end up with $11,700.

Alternatively, if you maintain your 60% allocation to stocks by rebalancing the portfolio at the end of the year that your allocation rises above 65% stocks, you will have a total account value of 15,300. If stocks now decline by 35%, your 60% allocation will limit portfolio losses to 21%, or a decline in portfolio value to $12,100.

By using a properly allocated and rebalanced portfolio, you will have less of a wild ride up, but save yourself the terror of the rollercoaster ride down.

Keeping Emotions in Check

With the above examples, would you have stuck it out during the downturn? In reading the first example, I’m sure you would have been emphatic that you would have stuck to your guns. However, after reading the second example, maybe you’re not so sure.

I think that educated investors know that their stocks are not going to go to zero. Therefore, during a downturn, they’re not thinking about losing all of their money forever. Instead, the siren song of “they’re not losing as much as me” or “maybe I was taking too much risk” creeps in and they change their allocation at or near the bottom. It’s the comparison game that comes in to bite us!

It’s important to manage your emotions as an investor. I think the easiest way to do so is to dial back your risk when times are good, so to limit your risk during those downturns. Sure, the loss of upside will be painful, but let me be clear, the pain in the downturns is exponentially worse!

The best way to systematically reduce risk is by rebalancing when your allocation gets out of whack. This works during the downturns as well, allowing you to replenish your stock allocation as markets are falling and stocks get cheaper. Once again, this takes emotions out of the picture, allowing you to maintain the target allocation and make purchases while others are running from stocks.

Academic literature would say that rebalancing hinders accumulation of wealth, since letting your stock allocation continue to rise will statistically increase future returns. The higher stock allocation is self perpetuating since stocks rise more often than they fall.

However, if your ultimate goal is to reach the end of your life with enough money to meet your spending needs and leave money to heirs, you don’t need to target infinity, just a number greater than $0. Limiting your risk, while eliminating the chance to reach infinity, will allow you to sleep better at night, all while helping you achieve your goals. Heck, it may allow you to live longer by reducing the chances of a heart attack when you open those brokerage statements way in the future!

Want to read more from FI-nancial Planner? Check out his other articles here.

Why Investing Conservatively Is Better

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7 thoughts on “Why Investing Conservatively Is Better

  1. Hi Danny,
    I think that this is great advice for people that are nearing their retirement date. However, would you give the same advice to someone in their 20’s with an average savings rate (for average Americans not FI community) and may not be able to retire for 20-30 years? Assuming that they enough self control to know that when a bear market occurs the losses they experience are just on paper and not actually realized.
    Additionally, what advice would you give to the 20-something year old who is hoping to hoping to aggressively pursue an early retirement (say 10 years down the road), however they are willing to work a few extra years incase their is a down turn in the market?
    Great post all around! Just wanted to get your thoughts on a couple different scenarios.

    • Hi Jon, thanks for the question. You’re absolutely correct that over longer periods of time, a 100% stock portfolio would have a higher likelihood of outperforming a portfolio with any level bonds. However, the assumption that an investor will stick to the strategy is a big one. Especially now that we are 9 years into a bull market, investor’s risk tolerances have gotten out of whack since the painful times are so far removed.
      The closer you come to the date of needing the money, your risk increases since you don’t have as much of a runway to recoup any losses (on average it takes 3-5 years to reclaim the previous bull market’s peak). Therefore, if you are looking 30 years out, a 80+% allocation to stocks may be prudent, but as the time frame gets shorter, an investor should reduce their risk exposure.
      For the second question, that 10 year period is too short to be able to reliably assume that stocks will outperform bonds. The period from 2001-2011 was essentially flat for stocks and up for bonds. Japan even had a ~20 year period where stocks went nowhere. With that said, an early retiree actually has a 70+ year horizon so they will need to include a healthy portion of stocks to sustain the portfolio for that long of a period.
      Working longer is a possible solution to a downturn, but why take the risk unnecessarily?

  2. I loved this article. I recently tried this and wrote a similar article on my blog fibythirty.com called “Student Loan Debt and Investing – What to do?”. It’s so important to find balance in your investing career, I couldn’t agree more.

  3. Great article Danny,
    That is an interesting perspective. I have never considered going to any bonds at all until I feel I am 3-5 years out from hitting the FI button and even then I may have more of a J.L. Collins approach where an index fund acts like enough of a balance.

    Do you think that a broad based index fund is sufficient to balance out a portfolio or would you still consider adding a percentage of bonds to the mix? For background, I am 34 and looking to be FI by 45 (based on savings and average market returns).

    • Broad based stock index funds still have the risks of stocks in the aggregate. If we go into a recession, it’s not as helpful to be spread out among 1000s of stocks since the index will be dropping by an average of 35% in the ensuing bear market.

      Meanwhile, having bonds will reduce that risk as they tend to stay flat or even increase in bear markets. The worst year in bonds was about a 3% decline. The purpose of them is to steady the ride and reduce volatility. Also, they keep powder dry so you have funds available to move into stocks when opportunities are presented.

      I think at this stage of the market cycle we are in (9 years into a bull) you should definitely have a stake in bonds. Volatility has been increasing and the odds are very high that we will have a recession and market correction at least once, maybe twice, before you reach FI (bear markets have historically occurred every 3-5 years). Not only would you preserve your investments in a downturn, but you would have funds available to jump into stocks when they get cheaper. I hope that’s helpful!

  4. Danny, with bond yields so low, why not use money markets and CDs returning 2-3% rather than bonds? At least they don’t go negative.

    • Randy, that is a great suggestion, especially with rates increasing (therefore raising money markets and CD yields while impacting bond prices). We consider bonds a “safety” asset in the sense that they won’t decrease in value nearly as much as stocks, but also tend to increase in value when stocks are dropping to the “flight to safety.” CDs and high yield savings accounts can definitely provide a similar benefit with zero principal risk.

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