Are Your Funds Too Conservative?

Is it possible to invest too conservatively? Yes it is. But it’s very case-specific. One Pilgrim’s conservative portfolio is another Pilgrim’s aggressive portfolio. Depending on your age, expenses, assets and income, your investments could be very conservative and just fine. But if you make the mistake of being too conservative (in your particular situation) you might actually be risking the very thing you are trying to protect most – your long-term financial security.

So how do know when your funds are too conservative?

Think about your situation over the long-term. If you have enough money to last and you don’t depend on investment income, you can invest however you like.

Of course, in order to know this, you have to do a little financial planning. But as I have written about before, this is not too difficult to do. You can either run your own financial projections or hire someone to do this for you. (I’ll give you some quick tips on how to do this yourself in a minute.)

But here’s a shocker – even if your projections indicate you’ll run out of money before you die it doesn’t necessarily mean you need to be more aggressive with your investments. That’s especially the case if your assets are very modest. Let me give you an example to clarify.

Jim is 60 and wants to retire in 5 years. So far, he’s saved $50,000 in a 401(k). He figures he needs an additional $20,000 in investment income each year on top of his expected Social Security when he stops working.

Using our safe withdrawal rule of 4%, we determine that Jim needs $500,000 invested in order to withdraw $20,000 a year without taking undue risk. But there is no way to take the $50,000 he has today and turn it into $500,000 in 5 years. In order to do that Jim would have to earn 58% a year for 10 years. That just might be asking too much. In this case, Jim should invest moderately, work longer and look for ways to reduce his expenses and increase his savings. His investment decisions aren’t the problem. His savings history is.

More often, I meet people with the exact opposite situation. In fact, I met a couple last month who were the polar opposites of Jim. These young people were in their 30’s, had excellent income and were saving like crazy. Their problem was indeed that they were investing too conservatively. This was very clear once they ran their projections.

They were by nature extremely conservative so they kept all their money in bank CDs – including their retirement funds. But because they are young and have many years ahead of them, they understood that if they don’t grow their money faster than inflation, they would never be able to retire despite their modest lifestyle and great savings habits. The good news is they only had to make a minor shift in how they invested in order to achieve their goals.

How To Figure Out If Your Investments Are Too Conservative

You don’t need to do a detailed financial plan in order to determine where you stand on this. Using a simple online calculator, you can get a lot of very important information. Let’s try this together.

Let’s assume you want to retire in 10 years. Further assume that you’ve saved $200,000 so far and will save an additional $20,000 a year over the next 10 years. You also figure that you’ll need an additional $25,000 a year from your investments once you retire.

Your first step is to figure out what you’ll need per year after inflation. Using the same calculator I referenced above you learn that you’ll need a little over $34,000 a year on top of your SSI if you retire in 10 years and prices rise by 3.2% a year (the average annual inflation rate over the last 20 years).

Let’s go on.

Using the calculator, you determine that the future value of your investments will be $498,000 if you earn 3% over the next 10 years and make the annual $20,000 contributions. If you multiply that result by 4% you realize that your investments will provide $15,000 each year 10 years from now. It’s not enough, but it’s not so bad.

Now, go back to the calculator and use 6% as the projected annual return rather than 3%. You figure that if you move your money from the ultra-conservative options to a balanced fund, 6% is reasonable over 10 years. If you run the numbers now, you’ll see that the value of your investments become $621,000 in ten years. That yields $24,800 annually which is close enough mon ami. This is a textbook case where your investments were too conservative and a minor shift makes all the difference.

If you do this exercise you’ll know if you are headed in the right direction or not. Keep in mind that this gives you a rough idea only. In order to know if you will have enough money to last, you really need to do a more detailed plan. Also, keep in mind that using balanced funds to grow your money probably won’t yield 6% each year. There will be good and bad years and you have to be ready for it. None-the-less, this can be a reasonable approach.

Bottom line? You can see that there is no “one size fits all”. The only way to know if your investments are too conservative or not is to run some projections.

Are your funds too conservative? How do you know?