Why Aggressive Portfolios Are Usually Safer Than Conservative

Learn why the standard portfolio risk categories are misnamed, why your bank is asking you the wrong questions, and how “risk” is misunderstood.

Many (maybe most?) investors are invested suboptimally and unnecessarily underperform with their retirement portfolios because of how financial institutions and advisors present and discuss risk. The term “investment risk” is vague, generic, and often misused and misunderstood.

Are You “Balanced”?

Financial institutions are required by law to ask about your goals and preferences before offering you financial advice (i.e. know your client [KYC]). For example, here are a few representative risk-related questions they could ask:

Capital Safety

1. The safety of my investment is paramount and I’m willing to accept limited income/returns.
2. I am cautious but will accept some investment risk to achieve my objectives.
3. I seek a pragmatic balance between risk and return.
4. I am willing to accept higher-than-average investment risk.
5. I am willing to accept significant risk to my investment capital in order to maximize my expected return or income.

Risk Aversion

1. Potential losses only
2. Potential losses more than potential gains
3. Balanced between potential losses and gains
4. Potential gains more than potential losses
5. Potential gains only

Risk Tolerance

1. Low
2. Below Average
3. Average
4. Above Average
5. High

I expect most people will tend toward the middle for this style of questions. On a scale of 0–10, most people don’t want to be a 0 or 10—they like to be a 6 or 7 (or maybe a 3 or 4). We’ve been trained to seek a balance between risk and reward. But, as I’ll discuss below, the risk they’re talking about in these questions is not what you think it is.

Are You “Aggressive”?

Financial institutions typically divide portfolios or funds into broad categories like conservative, balanced, and aggressive. The problem is these names may bias you towards a particular portfolio based on your temperament or personality. For example, you may associate aggressive with being reckless, foolish, high risk, gambling, “making an all-out effort to win or succeed; competitive”. You may dismiss the aggressive portfolio if you don’t identify as an aggressive person. Similarly, you might associate conservative as being wise with money, prudent, safe, “cautiously moderate or purposefully low”, and you could be swayed in that direction.

I’d consider myself reasonably risk-averse. I’ve never been interested in casinos or lottery tickets. My wife “tests” as very conservative on the risk temperament scale. Her bank encouraged her to invest extremely conservatively in her 20s despite having a safe job and being decades away from retirement. And yet, we’ve never invested our long-term retirement savings into anything other than so-called “aggressive” assets (i.e. 100% stocks—primarily ETFs). To understand why I believe this is not only sensible but prudent, we first need to differentiate some different types of risk.

Cone of Uncertainty

To illustrate the concept of risk, imagine a company you like or follow (e.g. Apple, Tesla, Facebook, Disney, NIKE). Over the next 12 months, they could have a very positive event (e.g. tripling their revenue or creating some revolutionary new product) or a very negative event (e.g. going bankrupt). The chance of (risk of) these outcomes is likely improbable (unless you’ve chosen a very speculative business). However, over the next five years, the probability of those very positive or negative events increases significantly. Over the next 50 years, one of those outcomes is virtually assured—the cone (or distribution) of uncertainty and expected outcomes grows as the timeline expands.

The same thing is true of the overall market. The chance of a recession over the next 12 months is lower than over the next five years. And during the next 20 years, a recession is all but guaranteed.

So, if you’re seeking to avoid risk, it’s logical to prefer assets with less uncertainty. For example, we’re often told to favour bonds or treasuries over stocks—they make us feel like we’ve reduced some of this uncertainty.

But this is where the counterintuitive part comes in. While uncertainty increases over time in each element of our portfolio, if we hold a strong, high-quality, diversified portfolio, time will naturally cause this uncertainty to balance or even out. Economic expansions will follow recessions. Most of our assets will grow, a few will dramatically outperform, and new ones will replace the few that fail. The cone of uncertainty for our overall portfolio will shrink over time (rather than expand), and the predictability of our returns will improve.

More Time Leads To Less Uncertainty

To demonstrate, I’ll use simplified approximations of the typical model portfolios to show long-term results going back to 1928 (data).

• Aggressive — 100% stocks (S&P 500 Index)
• Balanced — 60% stocks + 40% bonds (US aggregate bonds)
• Conservative — 40% stocks + 60% bonds

As a specific measure of risk aversion, I want to reduce the chances of the worst case (i.e. lowest returns) while balancing that against the nominal case (i.e. average return).

Note that I’m using inflation-adjusted returns because otherwise, periods of high inflation can dramatically overstate how much the value of our portfolio is actually increasing.

1-Year Inflation-Adjusted Returns, 1928–2022

Over any single-year period, investing in the aggressive portfolio would justifiably be called riskier. While there is a 2:1 chance that we’ll outperform the balanced portfolio, the worst-case returns are lower.

15-Year Rolling Inflation-Adjusted Annualized Returns, 1928–2022

25-Year Rolling Inflation-Adjusted Annualized Returns, 1928–2022

Over the longer time horizons, the results become much more interesting—the range of returns (our cone of uncertainty) has narrowed considerably. For all the rolling 15-year periods, the worst-case returns have tilted slightly in favour of the aggressive portfolio. Over the 25-year windows, the worst-case returns are noticeably better while still maintaining an advantage in the average case. So, by my definition, this makes the balanced and conservative portfolios riskier than the aggressive portfolio over the long term—the likelihood of underperforming is higher regardless of whether you look at the best case, average case, or worst case.

Unfortunately, bonds haven’t been attractive long-term investments for many decades. The main benefit of bonds is they’re supposed to be safer than stocks—but they’re not. Bonds can and do lose value. For example, they lost 25% during 2020–2023, and their annualized return from 2003–2024 is 0% (besides yield). Bonds are less volatile than stocks, making them safer short-term investments. However, short-term volatility is unimportant for long-term investing because it balances out over time.

And in case you’re curious, the periods with the worst 15-year performance for these portfolios were from the mid-60s through the inflation-ravaged 70s, before the bull market of the 80s. The periods when the balanced portfolio outperformed the aggressive one starting in the mid-90s, hitting both stock market crashes in the 2000s, but before the markets had a chance to recover. In both scenarios, it’s a short-term phenomenon—wait a few additional years, and the performance of the aggressive portfolio rebounds and makes up the difference.

The Real Trade-Off

Whenever a financial advisor talks about risk, I always stop them and ask them to clarify what type of risk they mean. Do they mean volatility (i.e. short-term risk) or speculation risk (i.e. long-term risk)? It’s essential to differentiate these terms because they mean radically different things. Volatility is mainly due to sentiment changes from geopolitical or news-related events (i.e. factors external to your investment). Speculation risk comes from potential problems directly related to your investment. Market volatility is temporary and affects all assets—but speculation risk is not.

Put another way, speculation risk is “the probability I won’t get to where I want to go”, and volatility is “how exciting the journey will be along the way”. For our retirement savings, the logical goal is predictably good returns by the end of our investment time horizon. If that time horizon is 15+ years, the aggressive portfolio is the safest choice, as demonstrated above.

So, how did we get led to believe that the more conservative portfolios were safer over the long term? If you look back to the risk questionnaire at the top, you’ll notice that you can replace every instance of risk with short-term volatility—that’s what they really mean. Do you want to accept lower returns to get less short-term volatility?

1. The safety absence of short-term volatility of my investment is paramount and I’m willing to accept limited income/returns.
2. I am cautious but will accept some investment risk short-term volatility to achieve my objectives.
3. I seek a pragmatic balance between risk short-term volatility and return.
4. I am willing to accept higher-than-average investment risk short-term volatility.
5. I am willing to accept significant risk short-term volatility to my investment capital in order to maximize my expected return or income.

I bet you think about higher-risk investments as more unwise or speculative investments. The bank usually means more short-term volatility when they say higher risk. None of the bank’s standard portfolios or funds are speculative or “risky”—they invest in financially stable, solid assets. However, the aggressive portfolio certainly has more short-term timing risk due to its higher volatility.

Speculative and volatile are not necessarily dependent—an asset can be one, both, or neither. For example, here are a few assets that exemplify each combination:

• Higher volatility and more speculative — crypto, startups, highly specialized/concentrated niche funds, most hedge funds
• Lower volatility and more speculative — leveraged hedge funds specializing in low volatility, complicated financial derivatives (as Warren Buffet calls them: financial weapons of mass destruction)
• Higher volatility and less speculative — stock index ETFs, stock mutual funds
• Lower volatility and less speculative — bonds, treasuries

The bottom line is you cannot simultaneously optimize for being a short-term and long-term investor because volatility and returns are strongly correlated. By investing in the typical balanced (or conservative) portfolio over the long term, what you’re effectively saying is, “I’d prefer the money (which I’m not going to need for 25 years) to grow half as much because I don’t like seeing it go up and down in the meantime”. Too harsh? Perhaps. But that’s the reality of the historical evidence.

Trust and Volatility

If you’re committed to investing for the long term, you can’t care about what happens in year 6 of 25. But to commit to a strategy and not have it keep you up at night, you must trust it. I suspect a common problem is investors don’t understand the specifics of what they’re investing in, nor do they respect the natural cycles of the market. So, it’s unsurprising that “number go down = bad”.

“Know what you own, and know why you own it” —Peter Lynch

The first step to overcoming the fear of volatility is building trust in your portfolio. If you don’t understand your investments, it’s about time to start. If your portfolio is too complicated, simplify it (own fewer things or more straightforward assets). I can suggest a few simple strategies, but any standard fund your bank recommends will be very safe (non-speculative) over the long term. Just choose the most aggressive (growth-related) versions to reap higher returns. For that matter, any broadly-based equity ETF or mutual fund will also be safe in the long term because they invest in well-established, financially stable companies.

The second step is to accept that volatile is different from speculative. Overall, market volatility is normal and healthy. The natural stressors of the free-market system lead to the survival of the fittest—we need it to weed out the weak and mismanaged companies. Market volatility will even out over time. A simple question to ask yourself whenever you’re concerned about an investment declining is whether anything has changed specific to your investment or whether this is simply related to the overall market. If it’s the former, you may want to reconsider your investment. If it’s the latter and your thesis is unchanged, you can safely ignore it.

The two logical options for dealing with volatility are: (1) to treat your portfolio as a magic box—put money in, don’t watch it, and then more money comes out at the end. Or (2) you can cheer (as I do) when markets go down—you have an unexpected opportunity to buy more high-quality assets on sale. If you’re contributing to your investments on an ongoing basis (as you should), volatility is a benefit and will boost your overall returns.

Key Points

• Optimizing to reduce short-term volatility usually guarantees lower long-term returns—they are strongly correlated. Decide if you’re a short-term investor (and need to worry about volatility) or a long-term investor (and worry about worst-case returns rather than short-term volatility).
• Buy high-quality investments and trust the process—if you lack conviction or have doubts, you’ll make worse choices.
• Owning a diversified portfolio of 100% high-quality stocks via an ETF is the most logical and safest choice for the average long-term investor.
• If your financial advisor suggests conservative long-term investments because of your risk profile, explain that you’re more concerned about long-term risk (and low returns), not short-term risk (and volatility).
• Your investment timeframe should be the critical determinant for portfolio selection, not your temperament. Expecting and embracing the natural market cycles is a skill you can learn.
• Avoid speculative assets but accept volatility for what it is—a short-term distraction.
• You ought to fear underperformance more than short-term fluctuations because compounding will magnify that underperformance 10-fold over time.

Points to Ponder

• What if the standard portfolios or fund categories were named short-term, medium-term, and long-term rather than conservative, balanced, and aggressive? Would you choose differently?
• Is reducing short-term volatility really worth earning half as much money in the long term?
• Is your financial advisor giving you wise advice or safe advice? Are they telling you what they think you want to hear (and expect to hear) or what you need to hear?
• If an investment concerns you, ask yourself why: is it speculative (has long-term risk), volatile (has short-term risk), or both?
• Are you confident in your investment portfolio? What would it take to be more so?

Related Concepts

• Why Compound Interest Is the Secret to Growing Your Wealth
• Why Passively Managed, Low-Fee Index Funds Are Ideal Assets
• Why Dollar-Cost Averaging Outperforms Lump-Sum Investing

If you have comments, questions, or constructive feedback, you can contact us by email at questions@essentialsofinvesting.com.