The risks of conservative investing

Last week, I wrote about how millions of younger investors are turning away from the stocks, opting for less-risky investments over an equity market that's provided lower-than-average returns with higher-than-average volatility over the past decade.

While that's certainly an understandable -- even human -- reaction, the question remains: Is it smart?

The answer is almost certainly no. It's rarely wise to chart your course by looking in the rear-view mirror at the market's recent performance, for two primary reasons. First, what the market has done in the recent past has no relationship to what it will do in the future. Second, such decisions are bound to be driven by your emotions -- you'll be optimistically loading up on stocks when they're soaring, and fearfully bailing out of them when the market's in the tank. In other words, you'll end up buying high and selling low.

Consider the impact of sitting on the sidelines after the market's last long stretch of disappointing returns. From 1966 through 1981, the annual return on the S&P 500 was -1 percent in real terms. Then, as now, investors found themselves concluding that the stock market just wasn't worth the headaches it produced. An infamous BusinessWeek cover story in 1979 pronounced "The Death of Equities," which said that essentially everyone who knew better had given up on the stock market.

You likely know what happened next. In 1982 a bull market of historic proportions commenced, an 18-year period of nearly uninterrupted gains. By the time that bull market ended in early 2000, the S&P 500 had produced an average annual real return of 15.5 percent. At that rate an investment of $10,000 would have grown -- in inflation-adjusted terms -- to $121,500 by the end of the period.

So much for the death of equities.

But the problem is that very few investors reaped those full rewards.

Those who had (incorrectly) determined that the stock market was nothing but a mug's game and adjusted their allocations accordingly likely ended up missing at least a few years' worth of those bull market returns before ultimately deciding to ditch their conservative approach.

How much of an impact would missing a few years have? Waiting just two years to get back into the stock market would reduce the value of that nest egg from $121,500 to $87,700 -- investors would have missed more than a quarter of the total return that was available. Waiting five years would reduce it to $57,400, less than half of the return they might have had.

This doesn't mean, of course, that investors today should load up on stocks in anticipation of another 18-year bull market. But I suspect that many, if not most, of those younger investors who have opted for a more conservative portfolio have done so not because they've developed a well-considered alternative approach to achieving their long-term goals. Rather, most have probably dialed back their risk simply because they're tired of having little to show for their faith in the stock market, other than a few battle scars.

As I said at the outset, that's an understandable response. Just as it's understandable that after a few years' worth of strong returns, most of these investors will decide to rethink their risk profiles.

But the fact that those responses are entirely human doesn't mean that there aren't real, tangible and potentially significant costs to allowing one's emotions to ride in the investment saddle.

So if you find yourself reconsidering your risk tolerance, make sure that you're not only accounting for how such a change will impact your ability to reach your long-term goals, but also how you'll respond when such conservatism isn't rewarded.