You Can Be Too Conservative

March 22, 2007

Yes, Virginia, you can be too conservative: even for risk-averse investors, stocks make sense.

Tennis elbow, or lateral epicondylitis, is the most common injury in patients seeking medical attention with the complaint of elbow pain. The condition is caused by small tears of the tendons that attach the muscles of the forearm to the arm bone at the elbow joint. If the condition deteriorates, tendonectomy surgery may be required. Unfortunately, I have had to undergo two such surgeries. Fortunately, my surgeon believed in aggressive post-surgery therapy. I was out of a cast and began physical therapy within one week. Within several months, I was free of pain and back on the tennis court.

On the other hand, I have friends who have undergone the same surgery, but their doctors proscribed more conservative treatment. They were in casts for significantly longer periods and their physical therapy regiment was less aggressive. As a result, their recovery periods were much longer. The most conservative strategies are not always the most appropriate. This is certainly true when it comes to investing.

As we approach and enter retirement, our ability to take on financial risks decrease. One reason is that, with a shorter investment horizon, we have less ability to wait out the inevitable bear markets. Another is that, if we are no longer working, we don't have the same ability to replace or recover from financial losses. And a third is that our willingness to take risk, and suffer the psychological strains that bear markets can produce, is in all likelihood reduced. Thus, it is logical for investors to lower their equity allocations when they reach, or even approach, the retirement stage of their lives. However, as you will see, it is possible to become too conservative. Let's look at the historical evidence.

 We begin by considering the cases of investors A, B and C. Investor A is so conservative that he invests all of his financial assets in long-term government bonds. Investor B is also conservative. While he invests the majority of his financial assets in long-term government bonds, he decides to allocate a small portion (20 percent) to stocks. That allocation will be in the form of an investment in the S&P 500 Index. Investor C is a bit more aggressive, allocating 30 percent of his portfolio to the S&P 500 Index. The time frame we will consider is 1926-2006. The following table shows the returns and standard deviations (a measure of volatility and risk) of each portfolio.

 

Investor A

100% Bonds

Investor B

80% Bonds/20% Stocks

Investor C

70% Bonds/30% Stocks

Annualized return

5.44%

6.78%

7.38%

Annual standard deviation

9.21%

8.80%

9.33%

Worst year

         -9.19% (1967)

       -12.92% (1931)

       -16.73% (1931)

Worst year post 1937

         -9.19% (1967)

        -5.96% (1994)

        -6.10% (1969)

We can make the following observations from the above data:

· By adding a small allocation to stocks (20 percent), investor B earned 25 percent greater returns and experienced 4 percent less portfolio volatility than investor A. Investor B's worst single year loss was greater than Investor A, but the loss was not that much greater-and the next greatest loss was under 6 percent. Note that if we only consider the post-Great Depression era, Investor A - the bond-only investor - would have experienced the greatest one-year loss. Importantly, this is not a suggestion to not consider the data from the Great Depression (that would be making the mistake of treating the unlikely as impossible), but it is worth noting.

· By increasing the equity allocation even further to 30 percent, investor C earned 36 percent greater returns, while experiencing only a 1 percent increase in volatility. However, the worst single year loss grew to almost 17 percent. Once again, we note that if we exclude the period of the Great Depression, investor A would have experienced the worst single year.

Find your next ETF

Reset All