This article reviews some definitions and common psychology concepts behind investing for retirement
We’ll compare differences between conservative and aggressive portfolios—and layer in the concept of balanced portfolios
And we’ll learn why some investors may consider a more aggressive approach to investing (with a focus on retirement)
Time and time again, headlines pop up that investors, especially ones in their 20s, are investing too conservatively.
According to a Wall Street Journal analysis, younger investors’ most common money mistake is investing too conservatively, putting too much money into cash and bonds, and not enough into equities.
US News & World Report highlights that 41% of people ages 18 to 33 say the bulk of their savings is in savings accounts or CDs rather than invested compared to 22% of Boomers, 30% of Gen Xers, and 31% of retirees.
According to Dr. Robert Johnson, quoted in BankRate, “The biggest financial mistake people make is taking too little risk, not too much risk.”
It’s understandable. Between growing up during the Great Recession, graduating into anemic job markets, carrying record amounts of student loan debt, and dealing with the economic (and other) effects of the pandemic, it’s no wonder that many younger investors feel some hesitation when it comes to investing—let alone when considering whether to invest aggressively.¹
How do people become investors anyway?
A 401(k) is one main way that people first become investors. For many, it can be a great way to practice automating savings through routine payroll deductions and get a handle on how to invest with a particular goal in mind (in this case, retirement).
In this article, we’ll review key things that new investors need to know, including:
Definitions of an investment portfolio and common investments
Comparing the differences between conservative and aggressive portfolios
An intro to balanced portfolios and how those compare on returns
Reasons that an investor, even one in their 20s, may consider a more aggressive approach to investing (with a focus on investing for retirement)
Reviewing common psychological pitfalls that can get in the way of investment decisions (or even getting started with investing).
Check out our 401(k) and Retirement Learning Center for more resources like this one.
Back to basics: Defining investment portfolios and comparing investment strategies
Before we dive into defining what a “conservative” investing strategy might look like, and what differentiates it from an “aggressive” one, let’s first cover, at a high level, what’s in an investment portfolio?
What’s in an investment portfolio?
An investment portfolio can consist of a variety of financial vehicles, including, but not limited to, money market funds, bonds, stocks, and more.
Money market funds are a type of mutual fund developed in the 1970s that have relatively low risk and lower returns compared to other mutual funds. Typically, money market funds invest in high-quality, short-term debt securities and are either used to store cash or as an alternative to investing in the stock market. Although money market funds seek to preserve the value of investments at $1.00 per share, there is no guarantee. It’s important to note that money market funds are not FDIC-insured and the principal invested may lose value.
Bonds are debt securities. Borrowers issue bonds to raise money from investors willing to lend them money for a specific amount of time. When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. (When you’re buying a bond, note that they come in different credit qualities and risk levels. Read more here.) In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as the face value or par value of the bond, when it matures (or comes due) after a set period of time.
Finally, stocks are a type of security that gives stockholders a share of ownership in a company. Stocks are considered a riskier investment vehicle when compared to money market funds or bonds (in part because they tie the investor’s results to the performance of a single company).
What should you know about stocks?
There is no guarantee that the company will grow or succeed, which opens any investor to the risk of losing their money. In addition, stock prices will fluctuate as prices move up and down. Although stocks can offer a higher potential for growth, they also offer a higher risk.
Investment portfolio options with Human Interest
When choosing your investment portfolio, you’re trying to strike the right balance of risk and reward. You want to get the highest return potential, so long as it comes with what is, for you, an acceptable level of risk.
At Human Interest, we focus on diversification, asset allocation, and low fees when designing an investment lineup for retirement plans. The investments available in any company’s plan are at the discretion of the employer (aka the plan sponsor) but we offer them a range of mutual funds, including index funds, to choose from.
An index fund is a type of mutual fund that aims to track the performance of a financial market index, such as the S&P 500. The manager of an index fund purchases shares of the companies (or a representative sample) included in the index. Because of this, index funds may be referred to as “passive investments.”
Index funds can be beneficial to a portfolio because they help provide broad market exposure and generally have low operating expenses—or low fees (also known as “expense ratios”). Read more about our approach to building investment lineups.
What’s a conservative vs. an aggressive portfolio?
A conservative investment portfolio is generally more weighted toward bonds and money market funds (generally meaning 50% or more of your nest egg is invested in bonds). This portfolio design offers the possibility of lower returns, but also may provide the investor with lower risk. This portfolio may suit investors who are more scared of losing money than not making money.
For example, if an investor is retired and these funds are their sole source of income, they might consider a conservative portfolio. Or, they may be more prudent for investors who are near their retirement date. Depending on your goals, retirement timeline, and appetite for risk, a conservative portfolio may be less ideal for investors who feel worried about missing out on growth early on that can compound over a 20-, 30-, or 40-year savings horizon.
An aggressive investment portfolio, generally, is more weighted toward stocks (e.g. think 50% of your nest egg is invested in stocks). An aggressive portfolio may suit investors who feel they can handle a few bear markets in exchange for the possibility of overall higher returns. Or, they may appeal to those who feel comfortable holding onto their investments.
Risk: Comparing risk across portfolio types
The amount of risk also can vary widely within different investments.
A more aggressive portfolio may feature small-cap growth stocks (often, stocks from smaller public companies that analysts consider poised for strong performance).
A less risky (yet still aggressive) portfolio may focus more on blue-chip stocks (stocks from companies known for their ability to weather market conditions over the long term).
And finally, a balanced portfolio seeks to strike exactly that: A combination of conservative and aggressive investments together in one portfolio.
The theory is that this arrangement would help position you as an investor to balance risk and, if the market gets stronger, get the highest return potential based on what you determine is an acceptable level of risk.
What is a balanced portfolio?
The goal of a balanced portfolio is to hedge against volatility. This typically involves investing in a combination of both stocks and bonds. One commonly used method for building balanced portfolios comes from Modern Portfolio Theory, pioneered by Harry Markowitz, one of the most famous American economists. Modern Portfolio Theory, also known as MPT, is a strategy designed to help investors optimize their portfolios and seek to maximize their return for a given level of risk. The specific tactics involved in constructing balanced portfolios vary widely, but tend to include:
Identifying the threshold where an investor is comfortable vs. not. Put another way, the question may be worded “how much money are you willing to lose over a defined period?” or “how comfortable are you weathering ups and downs (or volatility) in your portfolio?”
Assembling a mix of investment vehicles in a portfolio. While the ratio of stocks, bonds, and cash may vary for any investor, they also likely vary by age or life stage (e.g., how close or far you are from retirement).
Aligning with your investment goals. The unique situation, needs, and goals of any investor must be considered when constructing any portfolio, including any balanced portfolio, to ensure that you have a combination best suited to you.
Comparing risk and reward: conservative, balanced, and aggressive portfolios
So what can the risk and return profiles of conservative, balanced, and aggressive portfolios look like? It depends on the market, which brings with it a lot of variation.
To illustrate this variation, Vanguard created hypothetical model portfolios using market indices as asset class proxies. Said another way, Vanguard used the historical returns of various market indices, compiled into their model portfolio allocations, to compare the risk and return expectations of different objectives (from 1926 through 2021). The composition of these portfolios ranged from 100% bonds to 100% stocks and several allocations in between. Vanguard categorized their model portfolio allocations based on goals, ranging from “Income” (100% bond) to “Growth” (100% stock).
For the purposes of our discussion, we’ve categorized the 100% bond portfolio as conservative and the 100% stock portfolio as aggressive. It is important to note, you cannot invest directly in an index and, unlike mutual funds, index returns do not reflect any fees or expenses. While the index returns are historical, the returns of Vanguard’s model portfolio illustrations are hypothetical. Here’s a sample of their findings:
|Portfolio type||Average return (1926-2021)||Single-year best return||Single-year worst return|
|100% bonds (conservative)||6.3%||45.5%||-8.1%|
|50% bonds; 50% stocks (balanced)||9.3%||33.5%||-22.5%|
|100% stocks (aggressive)||12.3%||54.2%||-43.1%|
Source: Vanguard, 2021. Hypothetical illustration not intended to represent the past or future performance of any portfolio or investment. When determining which index to use and for what period, Vanguard selected the index they deemed a fair representation of the characteristics of the referenced market, given the information currently available. For U.S. stock market returns, Vanguard used the Standard & Poor’s 90 Index from 1926 to March 3, 1957, and the Standard & Poor’s 500 Index thereafter. For U.S. bond market returns, Vanguard used the Standard & Poor’s High Grade Corporate Index from 1926 to 1968, the Salomon High Grade Index from 1969 to 1972, and the Barclays U.S. Long Credit Aa Index thereafter. For U.S. short-term reserves, Vanguard used the Ibbotson U.S. 30-Day Treasury Bill Index from 1926 to 1977 and the FTSE 3-Month U.S. Treasury Bill Index thereafter. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
There are a few things you may notice in the above example:
This example covers a nearly 100-year period, which is an unlikely real-life scenario for any investor given that the average life expectancy was much lower than that during the entire 20th century or through today.
On average, the return from the conservative allocation is lower than the return on a portfolio that includes at least some stocks.
The single-year best return was from stocks, but the return on the 50/50 portfolio, in this case, was lower than the return on the all-bonds portfolio.
There is enormous variation in the returns across all three portfolios. Within the three examples, the 100% stocks portfolio had the largest range between its worst and best returns, which illustrates the potential risk. During this hypothetical decades-long time horizon, the portfolio experienced a year with a 54% return and another with a 43% loss. Compare that to the all-bonds investor, where the best return was 46%, yet in the worst year, their losses were much lower at 8%.
Why would an investor consider a more aggressive portfolio?
There are many reasons you (or any investor) may want to consider investing aggressively. Read more, and consult a financial professional to figure out your best course of action.
Reason 1: You don’t expect to need the money anytime soon.
If you’re already retired or about to retire and your 401(k)’s value plummets, you could find yourself in a tight spot. This is what happened to many people during the Great Recession. Researchers at the New School for Social Research found that among workers aged 51-59—presumably those nearing a transition out of full-time employment and motivated to shore up savings for retirement—45% saw their balances decrease by thousands of dollars between the spring of 2009 and the fall of 2011. While recovery is often marked by gains in the overall market, what these trends mean to individual investors may vary. The New School research team pointed out that if someone had $10,000 in 2008 and lost 25% of it, they’d need a gain of 33% just to stay even. If you’re on the cusp of retiring and planning to start withdrawing assets from your 401(k), you may not see the magnitude of change you want (or need) in your own account to meet your timeline.
However, if retirement is decades away, you could be better positioned to recover those losses. When retirement is further out, your account may be better able to withstand market fluctuations, including losses. While stocks carry a higher level of risk, meaning they have a track record of fluctuating in value more than cash or bonds, they also have historically delivered stronger annual returns.
Reason 2: Small differences can grow over time.
You may hear compound interest cited as a reason to contribute to your retirement funds as early as possible (and we believe investors should!). Usually, compounding refers to how a small amount of savings builds up and accumulates over time. But the reverse is true, too. Lower, smaller returns can mean that an investor with a lower risk tolerance could lose out on the compounding of their returns over time. (For example, read more in Kiplinger about how the wage gap persists over time.) By investing in a more conservative portfolio, you’re choosing both lower risk and accepting that, in turn, your returns may be lower.
If you choose a more conservative portfolio, you may experience smaller returns when markets perform well, compared to someone who invested more aggressively.
Reason 3: You know retirement investing should be for the long term.
One of the hardest problems we face in our lives is saving for retirement. It requires significant savings to pay for the last quarter of your life. It also requires committing to a long-term strategy. Yet it’s not always easy to stay the course. A market downturn resulting in your account balance dropping can drum up emotions that tempt you to back away from your well-thought strategy, pull out of the market, or even withdraw your funds. Recall your timeline. People investing for retirement typically aren’t investing for two or five years from now—they’re investing for retirement decades in the future.
In the interim, market fluctuations are likely to occur. Trying to time the ups and downs of the markets can be tempting. But we believe a portfolio allocation—whether conservative, balanced, or aggressive—based on the investor’s age and risk tolerance, along with regular contributions to the portfolio, is what really matters. One of the goals of passive investing is to choose a strategy you feel good about over the long term and then stay hands-off. Watching every single up and down can feel much more stressful than checking in less frequently to help make sure that you’re tracking over a longer time horizon.
Reason 4: Your portfolio is powered by automatic rebalancing.
As part of our services, Human Interest offers complimentary rebalancing each quarter. On behalf of investors who opt-in to this service, we automatically adjust their investment mix so that the proportion they hold matches their preferred portfolio settings. While portfolio rebalancing does not assure a profit or protect against loss, it can help ensure the investments you hold match your risk tolerance and are aligned with your goals—whether you prefer a more aggressive or conservative portfolio.
Over time, the weighting of each asset class will change (because the returns on each asset class, or fund, are not identical). This means you’ll see a shift away from what you’ve outlined as your target investment mix. Typically, these are smaller percent changes, but they signal that the risk profile of your portfolio is shifting, too.
To get back on track with your target investment mix, you can rebalance your portfolio. Said another way, you can update your investments to match your target portfolio. Read How much should I put into my 401(k)? on our Learning Center.
If you’re looking for an automated, affordable 401(k) for your employees, click here to request more information about Human Interest.
Article ByEric Phillips, CFA
Eric Phillips, CFA, has dedicated his career to improving financial wellness. He began his career at Artisan Partners, a global asset management, firm and currently serves as the Senior Director of Financial Partnerships at Human Interest where he works with financial advisors and industry partners to help them offer affordable retirement plans.