Why Getting Too Conservative as You Age Can Hurt Your Retirement

(This is part of a series on making sure you're taking the appropriate amount of risk. For more on this topic, see Thursday's post Why Getting Too Aggressive When You're Young Can Hurt Your Retirement.)
As we approach and enter retirement, our ability to take financial risks decreases. We have less time to wait out bear markets and recover from financial losses. We're also likely less willing to bear the strain of bear markets. Thus, it's logical to lower your equity allocations as you approach retirement. However, it's possible to become too conservative.

We'll start by looking at four portfolios, rebalanced annually and covering the period 1926-2010 (the longest for which we have data):

• Portfolio A -- 100 percent 20-year Treasury bonds
• Portfolio B -- 90 percent 20-year Treasury bonds/10 percent S&P 500 Index
• Portfolio C -- 80 percent 20-year Treasury bonds/20 percent S&P 500 Index
• Portfolio D -- 70 percent 20-year Treasury bonds/30 percent S&P 500 Index

The conclusion we can draw from the evidence is that adding a small amount of equities to an all-bond portfolio can raise returns while actually reducing volatility. The reason is that while stocks are more volatile than bonds, stocks have a very low correlation to bonds. The annual correlation of the S&P 500 to long-term Treasury bonds was just 0.07.

There are other ways you can improve the efficiency of your portfolio. The following three portfolios, rebalanced annually, should demonstrate this next point:

• Portfolio A is again composed of 20-year Treasuries.
• Portfolio B has 80 percent 20-year Treasuries and 20 percent S&P 500.
• Portfolio C also has 80 percent 20-year Treasuries, but splits the equity allocation evenly between the S&P 500 and the MSCI EAFE Index.

Portfolio C actually produced the highest return (as the full numbers were C's return of 9.34 percent versus B's 9.29 percent) as well as the lowest standard deviation.

Let's now look at another way to improve the efficiency of a portfolio, while still maintaining its conservative nature. This time we will shift the maturity of our bond holdings from long-term Treasury bonds to five-year Treasury notes, reducing term risk. Again, we'll use three portfolios, rebalanced annually:

• Portfolio A is 80 percent long-term Treasury bonds and 20 percent S&P 500.
• Portfolio B substitutes five-year Treasury notes for the long-term bonds.
• Portfolio C shifts the allocation to 60 percent five-year Treasury notes and 40 percent S&P 500.

As you can see, both Portfolio B and C were more efficient portfolios than A. Portfolio B had far less risk in return for slightly less returns, and Portfolio C had noticeably better returns for the same level of risk.

While it's appropriate for investors to become more conservative as they approach and enter the retirement phase of their lives, the evidence suggests that you can actually become too conservative. Doing so might cause portfolios to "fail," leaving investors alive without the financial assets needed to provide the lifestyle they worked so hard to achieve.

More on MoneyWatch:
5 Reasons to Avoid Variable Annuities John Bogle: Can His Son Beat the Market? Q&A: Should I Buy a 30-Year TIPS? How the Japan Earthquake is Hurting Commodities' Returns Quest for Alpha: 10 Rules for Being a Successful Investor
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