In a recent Wall Street Journal article entitled, “The Biggest Financial Mistakes Retirees Make,” reporter Cheryl Munk states that “the number one error, according to financial advisers: investing too conservatively.” It’s understandable, particularly when investor uncertainty is high, that fearful investors move savings into cash equivalents and very short duration bonds in order to reduce portfolio volatility. However, it’s important to recognize that while such portfolio adjustments do reduce volatility, they don’t eliminate risk. They merely transfer it from one source to another. As Ms. Munk says, “Playing it too safe can severely limit retirees’ earning potential, increasing the chances they’ll run out of money,” thus raising purchasing power risk.
This month marks the 10-year anniversary of the end of the Great Recession, and we now know what happened over the decade following one of this nation’s most severe economic downturns. Suppose that two months before the stock market bottomed in early March 2009, an investor, concerned about the future of the economy and the stock market, moved $100,000 from an equity portfolio earning an S&P 500 return into U.S. Treasury bills. Over the next decade, the investor’s $100,000 in T-bills would have grown to $103,246, a compound annual growth rate of 0.32%. Since inflation averaged 1.8% over this period, this investor’s purchasing power would have actually declined.
Alternatively, had the investor kept his assets in equities earning an S&P 500 return, his $100,000 would have soared to more than $343,000 over the same decade, earning a far higher return. In inflation-adjusted terms, the investor’s $100,000 would have risen to over $292,000. As this example demonstrates, the opportunity cost of being too conservative can be extremely high, and the inclination to be overly conservative is particularly strong after a market collapse that leaves many investors pessimistic and anxious about the future.
Of course, if an investor could successfully time the market, moving assets from stocks to T-bills just before bear markets and back into equities at the market’s trough, then his rate of return could be increased substantially. However, many studies have clearly shown that the great majority of investors fail miserably at market timing. One study found that market timers achieved returns of only a fraction of what buy-and-hold investors achieved over a given 30-year time period. Examining rates of return in the months following a market trough, it’s clear why timers predictably miss the exact turning point and are left far behind. In the first two months of 2009, the S&P 500 dropped almost 20% (after declining 37% the prior year)—imagine the mounting pessimism —but over the next 10 months, the market rose by almost 55%! After hitting its lowest point with rampant pessimism, the market surged ahead, but most timers were slow to reinvest in stocks. They waited until they felt better. Since the rapid 2009 recovery is characteristic of almost all past recoveries, long-term investors would be wise to avoid becoming too conservative when confronting future market downturns.