Even though the stock market recently has hit new 52-week highs, some investors may still be feeling conservative. But these risk averse investors need to make sure they are not avoiding one risk only to take on another - namely, inflation.
Conservative investors aren't willing to risk losing a lot of money despite the prospect of big rewards. They often prefer certificates of deposit, money market funds or other investments that tend to be much less volatile than stocks - even though historically those categories offer lower returns.
Over the last 30 years, stocks returned an average of 11.2 percent every year, versus a 5.6 percent return for so-called cash investments, according to Morningstar. When you factor in inflation, the stock market gains comfortably surpass the average long-term inflation rate of 3.6 percent - but cash investments leave just a 2 percent yearly return for investors.
So if 2008's 38 percent drop in the Standard & Poor's 500 index spooked you away from stocks, you must make sure your portfolio can still generate enough returns to outpace inflation and get you to your retirement goals.
If you are sure you prefer the stability of cash-like investments, to protect yourself against inflation, your other options are saving more or cutting back on future spending plans, says Darsi Ringer, a financial consultant with Charles Schwab. In the long-term, prices are going to go up, so the dollars you save now won't stretch as far in a decade or two.
Skittishness about stocks lingers on even despite this year's market rally. Based on research by Prudential Financial, 7 in 10 investors currently believe being too aggressive with investments is riskier than being too conservative. Two years ago, respondents were evenly split on the same question.
Shifting more of your portfolio to cash from stocks can, in the long term, mean you might miss your profit goals, says Stuart Ritter, a financial planner with T. Rowe Price. "You are making a move to protect yourself - but you have just increased your inflation risk," he says. "People often don't see that other risk." Many investors - especially those who watched a third or more of their nest eggs vaporize in 2008 - are more worried about the prospect of painful, short-term market swings.
But based on a T. Rowe study of actual market returns following the 1973 bear market, inflation and low returns should be just as much of a worry for an investor who prefers cash.
A retiree in 1973 with $250,000 balance who only invested in cash-equivalents would have run out of money three years shy of a 30-year retirement. That's assuming the retiree was making withdrawals that started at $10,000 and increased with the pace of inflation.
A less conservative retiree who stuck with 55 percent in stocks at the age of retirement, with a gradual shift toward 20 percent in stocks, would have more than $400,000 after 30 years, even after making withdrawals. The stock exposure helped that portfolio continue to grow, even though the hypothetical account began in a very bad bear market.