Save Aggressively, Invest Conservatively

Now we know the story that retail investors run for the hills whenever the stock market hits turbulence is largely a myth. Even during the serious financial crisis in 2008-2009, only 7% of the money invested in stock mutual funds were sold out of those mutual funds. However, even though most investors don’t sell, they do indeed become nervous when the market drops.

Buckingham Asset Management recently had to host not one, not two, but three conference calls to discuss the current situation with its clients: one before the debt ceiling deal was reached, a second one after the market fell sharply on Aug. 4, and a third one after S&P downgraded US debt. If clients weren’t worried, the advisors wouldn’t have had to do that.

While these events were unfolding, although the stock market is still down, I haven’t worried at all. All I thought was what I should buy. I attribute the peace of mind to having a conservative asset allocation, one that’s well below my risk tolerance. A conservative asset allocation keeps me calm.

With a conservative asset allocation, you don’t have a large loss when the stock market drops. For instance, with 45% invested in stocks, the Vanguard Target Retirement 2010 Fund (VTENX) lost only 6% between July 22 and August 19. Its sibling Vanguard Target Retirement 2030 Fund (VTHRX) lost 13% during the month because it has 80% invested in stocks.

If you have a conservative asset allocation well below your risk tolerance, you will have some wiggle room during uneasy times. Not only it keeps you committed to your investments, but it also gives you some capacity to think about increasing allocation to stocks when the equity risk premium is the highest.

UK investing blog Monevator wrote about a plunge protection fund. He talked about keeping a cash reserve. If you replace cash with bonds, it’s the same idea. A large dose of less volatile assets, or ideally assets that go up when stocks go down, will help keep you sane and let you buy at lower prices.

People are known to overestimate their risk tolerance. When everything is going well, there isn’t much concern for risk. The true test comes only when things are not going well. If someone is new at this, whatever asset allocation he or she comes up with, I would suggest knocking off the percentage for stocks by 10 to 15 points in order to leave some wiggle room.

Wouldn’t a conservative allocation have a lower expected return? Yes it would, but the peace of mind is worth it. You make up for the lower expected return by saving more. It’s much more reliable to hit a goal with more savings invested in a conservative portfolio than less savings invested in an aggressive portfolio.

Stocks have historically done better than bonds. The more you invest in stocks than bonds, the more likely you will have a higher return over the long term. But the higher return is far from guaranteed.

Stocks haven’t done better than bonds in the last five, ten, or 15 years. If you were counting on the better return to make up for lack of savings, by the time you see the return didn’t materialize it’s too late.

Invest conservatively but rely more on your own savings to reach your goal. I think that’s a much better approach than treating the higher expected returns from stocks as a free lunch.