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By Christine Benz | 09-27-2010 05:53 PM

Don't Let The Market Determine Your Risk Tolerance

Vanguard's John Ameriks says that investors shouldn't make asset allocation decisions based on short-term market fluctuations.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Finding the right stock bond mix is a hugely important question when managing your retirement portfolio, but it's one that investors often struggle with. Here to address that question for us is John Ameriks, he is Head of Investment Counseling and Research at Vanguard. John, thanks for being here.

John Ameriks: Thanks for having me. It's great to be here.

Benz: So, let's start with the key question these days which is, whether to take a more tactical hands-on, active approach to managing your asset allocation or whether you should be hands-off and strategic in long-term. What's your take on that question?

Ameriks: Well, the reports of the death of strategic asset allocation are greatly exaggerated, I would have to say. So, I know it's the same old story when there does seem to be a period that we go through where active managers struggle, folks start to talking about the utility of trying to get in and get out in front of the markets, but that remains just as much of a challenge today as it ever was.

And so we think for most investors there is a very strong role, continued role for strategic asset allocation, taking a risk tolerance questionnaire, finding out what portfolio might be the right fit for you given your risk tolerance and then sticking with that. That doesn't necessarily mean just set it and completely forget it. It means make sure that you rebalance on a periodic basis and get back to those targets, but those targets are of primary importance.

Benz: And periodically make the portfolio more conservative as you get closer to needing your money?

Ameriks: For most people, that does make an awful lot of sense and is in fact the main idea behind the target-date funds, that as people get older their ability to handle risk changes and a more conservative allocation will generally make sense.

Benz: So, one question I have for you John is that, when you look at 401(k) participant behavior, do you see that they tend not to make a lot of changes, and so would that argue for maybe dialing up the equity allocation if they are not particularly risk conscious and not paying attention to those big market downturns?

Ameriks: Well, I think it's all about the analysis you do around what level of risk is appropriate given someone's end goals. We do know that, while in general – I guess I was the one that many, many years ago myself and my dissertation advisor did some of the earliest work looking at inertia in a 403(b) plan actually. I mean what we found was very large fractions of the participant base not doing anything over very long periods of time.

But we also know that during periods of stress when there are bumps in the market, big bumps like there were in September of 2008 and through the end of that year, we do get some participant reaction. And so, that you are always trading off, at some level if things get bad enough, some people are going to be tempted to try to do something, and so you are always trading off risk and return. So we think that finding some middle ground in between a 100% extremely risky portfolio and something that's way too conservative is what's going to make sense for most people.

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