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When most people think about being a conservative investor, thoughts of keeping money locked away in an FDIC insured savings account, parked in CDs, or in government bonds. After all, what could be more conservative than that? The problem is that there is a difference between conservative investing and no-risk investing, but many people mistake it for the same thing.
With the previously mentioned investment vehicles, it appears that there is no risk involved–your money won’t go down in value and in most cases it’s insured or backed by the government. But what you don’t realize is you are subjecting yourself to hidden risks that aren’t as apparent. While you may not lose your principal investment, you’re still losing money. That’s because in times when people are most afraid of taking risk, it’s almost always in a low interest rate environment. That means even though you may be earning interest, you’re still losing in two ways: for starters, these investments won’t outpace inflation, and second, after paying taxes on any gains (not counting Roth IRAs) you’re losing even more. So, after factoring inflation and possible taxes on that money you will often end up still realizing a loss of at least a few percentage points each and every year even though it looks like your account value is increasing.
I know what you’re thinking: “but it’s better than risking it in the stock market where you could lose half your money in just a single year!” You’re absolutely right. If avoiding a big loss is your primary objective, then putting your money into cash, CDs, and government bonds is one way to do that. Unfortunately, that goes to the extreme other end of the spectrum and you begin doing more harm than good. There are ways to still maintain the security you’re looking for without actually losing money to inflation and eventual taxes. Conservative investments are popular these days when the common belief is that you can’t make money in the stock market. True conservative investing will provide a solid balance between safety and returns. I’m here to show you how.
Avoiding Stock Market Risk
If you’re thinking about conservative investments, chances are you’re trying to minimize or eliminate the inherent risk in the stock market. I don’t have to remind you, but just turn on the news or go to your favorite financial website and you’re bombarded with information regarding how the stock market is doing. Especially in recent years, it isn’t uncommon to see the entire market shift more than three percent in either direction in a single day. Clearly, this can create some sleepless nights if all you’re trying to do is keep your money moving in the right direction.
To show you what I mean, here is what it looked like if you had $25,000 invested in the S&P 500 (using Vanguard’s S&P 500 index fund) over the past ten years:
You can see how wild the ride has been. There are a ton of short-term peaks and valleys, and obviously, some much larger ones that stretch for years. In the end you will also notice that stocks ended pretty flat over a ten year period. Some people call this the lost decade of investing. This is pretty much the polar opposite of what a conservative investor has in mind. So that brings us back to the original reason for choosing to be a conservative investor. You are basically trying to smooth out all of the randomness in the market as visualized by this chart and create a steady upward sloping line which means you’re making money.
Using Conservative Investments
After determining that you want to stick to something conservative, where do you turn? As I pointed out earlier, banks and government bonds are obviously a safe alternative that can eliminate the risk to your principal, but you may also remember that this means you still ultimately lose money after taking into account inflation and potential taxes on the gains. There is some good news. Most fund companies provide already diversified portfolios for almost any risk tolerance, conservative included, so you can literally put your money into a single fund and take immediate advantage.
Here is what the past ten years looked like if you put the same $25,000 into Vanguard’s Wellesley Income fund:
Clearly, this chart looks incredibly different than the S&P 500 chart above. That’s because of how the money is invested. To give you an idea, it is comprised of roughly 57% bonds, 32% stocks, 5% cash, and a smattering of other investments. What a change to be made by holding mostly bonds and only a third in stocks. Suddenly most of the peaks and valleys are gone and it’s a far more steady line of growth. Granted, there was still a pretty significant drop in 2008 thanks to the financial crisis, so even this “conservative” allocation wasn’t quite enough to prevent some short-term damage. But in the end, this fund managed to average over 6 percent per year over this time period, and it still far outperformed the stock market as a whole. That’s not bad.
Let’s take things one step further. Clearly, all you staunch conservative investors out there are pointing to that drop during 2008 and saying that is unacceptable when you’re trying to protect your money. I agree, and I think we can still do better without resorting to earning less than 2 percent in government bonds or the bank. So, I’ve put together a custom conservative portfolio that is made up of three equal parts: a money market/cash fund, a long-term treasury fund, and a short-term investment grade bond fund. How did it do? I’ll let the chart do the talking:
Look at that. You can’t even spot the financial crisis of 2008-2009 in this chart. Even the last conservative allocation lost money during that period, but this portfolio kept on chugging. And notice there are no significant peaks and valleys, and for all intents and purposes, it’s a smooth line continuing to increase in value. Here’s the really good news: even though we got far more conservative, we were still able to achieve an average annual return of nearly 5 percent. Given what we’ve been through over the past decade, it is refreshing to see that there is still money to be made without taking on much risk. Most people just write-off the fact that safe investments will mean little or no return. But when you think outside the box instead of putting your head into the sand, there is still money to be made during even the rockiest markets.
Here is one last look. What if you did have your money parked in a cash-equivalent investment? Well, it isn’t very exciting:
Knowing Your Investment Goals
All of the above information is good, but it doesn’t mean anything without also looking at your goals for that money. For instance, if the money you are investing conservatively will be needed in just a few short years for a specific purpose (wedding, vacation, home or vehicle purchase, etc.) then the the absolute no-risk option of cash, savings, CDs, and such may be the best bet. But what if you are talking about longer term uses for that money? Whether it’s retirement, saving for college, or just trying to earn more money from non-emergency fund cash, as you can see from the examples above that there are conservative investment styles that can give you significantly better returns while introducing very little risk.
Let’s take a look at all of the previous investment choices and overlay them on a single chart:
As a reminder, each investment began with $25,000 and was held for the past ten years. The lines represented above are:
- Black: Cash/Money Market – Average annual return of 2% and cumulative return of 22.3%
- Gray: S&P 500 – Average annual return of 2.59% and cumulative return of 29%
- Green: A third each in money market, government bonds, and investment grade bonds – Average annual return of 4.75% and cumulative return of 59%
- Blue: A Vanguard conservative allocation fund – Average annual return of 6.2% and cumulative return of 82%
Assuming you are looking for a conservative investment to span ten years or more, which of those lines above would you be comfortable with? When compared side-by-side, the green line doesn’t differ much from the money parked in cash in terms of the risk of losing money, but look at how much better it performs over time. In fact, you would have earned more than twice as much money and had little to no risk of losing your principal. Finally, in all of these examples we’ve simply been looking at a lump-sum investment held for a decade. Obviously, most people continue to add to their investments slowly over time. This dollar-cost-averaging takes even more risk out of your investment. In addition, you’ll also want to be sure to rebalance your portfolio regularly, which helps as well.
What Kind of Conservative Investor Are You?
We’ve covered a lot of information here, but the big question comes back to you. Just what kind of conservative investor are you? As you can see, you don’t have to essentially hide your money under the mattress to keep your money safe. In the end, keeping all of your money in cash or savings has you actually losing money in the long run. Of course, this strategy is still good for certain circumstances such as emergency savings or money that will be needed in a short amount of time. But if you’re just someone looking to save money for the future, whether it be retirement or otherwise, there’s just no sense in letting your money sit around earning nothing when you can find a conservative investment strategy that can provide you with reasonable returns with very little added risk. Even if the economy and stock market has you feeling down, step back and take a look at what you really want your money to do for you.
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Filed Under: Investing
About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.
I think this clearly demonstrates that:
1) in the long run, equities out-perform
2) diversification is essential to reducing volatility and risk (PROPER diversification, as in across industries and asset classes)
3) to maximize long-term returns, investors need to stop paying gratuitous fees (I really wish we had 0.1% MER Vanguard funds up here in Canada)
This is truly open and inspiring article, Jeremy. Thank you a lot, it will help me a lot to understand my way to financial independence.
Did you take into account any taxes & inflation into the representation? I have recently did and it is amazing how the picture changes. Not only you are not gaining anything but you are actively loosing money!