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The heart of conservative investing lies in the low tolerance for risk. Conservative investors generally express that thinking through action when they weight their portfolios heavily in bonds and large cap domestic stocks.

A weighting like this will lower the apparent volatility of the portfolio. In fact, the volatility can get lower and lower as the proportion of bonds increases. This is the basis of the old saw about allocating your age in percentages to bonds during retirement. The common adage goes that since you can handle less risk as you get older, you should have less money invested in stocks.

Bonds are not "Safe Investments" for Retirement

In truth, allocating more money towards bonds is kind of like cheating. You don’t reduce the stock volatility so much as hide it. With 50% of your wealth invested in stocks, you should enjoy a total portfolio volatility of around 9% per year, versus the SP’s 18%. With an allocation like that, volatility has not truly been reduced however. The stock volatility has been hidden by putting bond allocations on the same statement. It makes for a rosy picture, but it’s not a prudent way to lower volatility and certainly it fails as a prudent method to preserve wealth over several decades.

Focus on Spending Power more than Account Balance

A truly conservative strategy would focus on conserving spending power rather than capital. The most important thing about your nest egg is that it provides you with the power to maintain your lifestyle over the course of your retirement. Most plans need to provide for the lifetimes of two retirees, with one surviving a bit longer than the other. In that sort of planning, the conservative investor’s worst fear should be inflation and taxes, even though volatility gets all the headline coverage.

Inflation is the Pensioner's Enemy

Average rates of inflation just about halve the value of a dollar over the course of 15 years. Volatility may do that to a portfolio once or twice in a decade, but at least it has an upside. Over the last thirty years (the length of time you probably will want your retirement to last) the market has had various ups and downs, most of which you can remember. Even so, its value doubled almost four times in spite of the bear markets that have interrupted its progress. Inflation has unrelentingly worn away the value of the dollar since 1978. The inflation threat is far more serious and constant than market volatility.

Prudent Investment Planning Fights Inflation Risk

In order to truly safeguard your wealth, you need to switch to a prudent paradigm when considering what to do with a nest egg that needs to produce income for several decades.

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Fear has investors run from risk and greed has them chase return. Neither emotion has a place in Prudent investing. The heart of Prudent investing lies in striking a balance between risk and return. No two concepts in investing come with more emotion wrapped around them.

When an expert advisor removes these emotions from the equation, she is left with a direct relationship between the two. Now she has a duty to mathematically analyze and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the portfolio she administers.

Your retirement funds need to be positioned in accordance with the needs of you and your family. A careful examination of your goals and requirements gives your advisor a sense of the type of return you’ll need going forward. Based on that number, a sensible strategy for risk management emerges. Your investments are placed with your goals in mind, not in accordance with a five minute risk tolerance questionnaire.

Volatility has Two Faces

Prudent long term investors distinguish between risk and volatility. The market prices for various investments change on a minute to minute basis during market hours and across weeks and years. Markets have bull and bear phases. While the press laments low stock prices and may fill the air waves with sentiments of fear and doom, smart investors realize that stocks may be had a bargain prices in some cases. Smart money buys at market lows.

Bull markets reveal the upside of volatility. Greed predominates as amateurs rush to buy equities that have risen in price lately. Smart money sells at these times. Prudent investors find that portions of their portfolios have risen in value so much that they must sell shares which have actually become overvalued. The proceeds allow her to purchase investments that others currently shun. In 1997, Porter Kickham clients invested heavily in foreign equities, as others chased technology. Now, these foreign equities have risen in value as domestic ones declined and sales of foreign stock allow them to purchase undervalued domestic shares.

Downside Risks Eventually Get Realized

No one who wants to live on retirement income can avoid volatility. Volatility can make the value of investments decrease. This becomes a problem during the distribution phase (retirement) when you may find yourself having to sell shares for less than you paid for them. Taking a loss in this manner is often unavoidable for some shares that you may own as a retiree, particularly in the early part of your retirement.

A Prudent spending plan assures that you won't sell a great deal of your shares in any one year, thus lowering loss potential. While unpleasant, such circumstances do not constitute failure of a retirement plan. A plan fails when you run out of money before you run out of the need for money.

Proper Diversification Lowers Downside Risk

Barring global catastrophe, a particular macroeconomic situation usually causes some groups of investments to fall while others rise. Prudent investment principles produce a portfolio that includes shares of each. This lowers the downside volatility of the total portfolio in the face of localized crashes or bear markets.

With a Prudent Investment Policy Statement, your advisor will use downside volatility to purchase lower priced shares. Generally, these have a higher expected return, since the price to earnings ratio should be lower when purchasing a good company which is undervalued because of market circumstances.

Buy-Sell Discipline in Action

This purely hypothetical example shows how a Prudent investor both survives and profits from market forces. After the September 11 calamity, the prices of most US stocks lost 15 or 20% of their value in a week. A conservative, blue chip investor would have seen quite a drop in his portfolio.

The events of that day did not mean that people had less need of the shampoos and hand soaps that Proctor and Gamble sold as part of its ordinary business, even though shares of the stock were much lower in the following weeks. A Prudent portfolio would have held share of P&G as well as shares across a global network of stocks.

A Prudent investor would have been holding gold stocks in her portfolio as well. These stocks rose in value with price of gold. Prudent investment policy demanded that the higher priced shares were sold to purchase the lower priced shares. Thus, some shares of Proctor and Gamble could be purchased at a bargain price which did not truly reflect the value of that company over the long haul.

Taking on Risk May Have Rewards

The vagaries of the market produce large swings in the prices of various indices and even larger swings in the prices of individual stocks. Random choices won’t necessarily lead to safety, but properly chosen groups of stocks give you a better chance at riding out most of the storms.

At market bottoms, television, radio and the internet will drive people to an emotional level of despair. A Prudent portfolio works in exactly these circumstances to cushion the blow and to rise in the aftermath. A Prudent advisor’s earns her money at these points simply by making sure that you, the client, do not give into the popular frenzy and sell out at the bottom. Over time, the market has shown that in most cases, those who stay the course recover and go on to prosper if they just stay with their plans long enough.