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Can Your Portfolio Withstand Volatility?

How to determine how durable your portfolio is and strategies to tame stock market risk.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The markets have gotten off to a jittery start so far in 2022, and some investors may be wondering whether their portfolios are positioned appropriately if volatility persists. Joining me today to discuss the topic is Christine Benz. Christine is Morningstar's director of personal finance and retirement planning.

Nice to see you, Christine. Thanks for being here.

Christine Benz: Susan, it's great to see you.

Dziubinski: If someone is trying to assess whether their portfolio can withstand volatility, what's the starting point?

Benz: The starting point is really to do a little bit of a self-assessment, so think about what your goals are and what your proximity is to them, and that will help you determine how much risk you want to have in your portfolio. So, if you're someone who is many years from retirement, you probably don't have to worry too much about risk in your portfolio. You should have all of the equity risk that you can handle. But if you're someone who has goals that are closer at hand, whether it's your own retirement or a home down payment or some other shorter-term goal, that's where you need to be mindful about right-sizing the risk that you're taking in that portion of the portfolio.

Dziubinski: Let's say, you've done the self-assessment. What's the first step then when it comes to actually assessing your portfolio and whether it's appropriately positioned?

Benz: Well, the first step is to take a look at your asset allocation because that will be the biggest determinant of how your portfolio behaves. I like our X-ray functionality for getting a read on asset allocation because it really does delve into holdings that you might have in your portfolio. If you have mutual funds, for example, it digs into what sorts of exposures they have. So, do that process of assessing your asset allocation. And then, you can think about the risk level in the portfolio. My bias is that many investors have gotten very comfortable with equity exposure. They've had a great experience in the stock market over the past 12-plus years, and so, they're comfortable taking equity risk. The problem is that they might be closer to needing their money, and they might have too much risk, too much equity exposure in their portfolios given that proximity to the spend down phase. So, spend some time assessing the appropriateness there. My view is that if investors have a time horizon of like eight or 10 years when they will start drawing upon their portfolio, they shouldn't have that portion of their portfolio in stocks. Some of their portfolio might be in stocks, but the portfolio that is set aside for near-term spending should not be in stocks. It should be in cash or bonds perhaps.

Dziubinski: Let's talk a little bit about bonds. Bonds have gotten rattled a little bit recently as well. So, investors might be a little bit nervous about them. So, how should investors be thinking about that bond sleeve in their portfolio today? How do they figure out how much they should actually hold in bonds versus maybe how much they should be holding in really stable assets like cash?

Benz: It's a tough question, Susan, and you're absolutely right that some of the volatility in the market has been in bonds. And so, I think investors do want to remember why they might hold bonds in their portfolio. The key reason is not return on principal. You won't get much in yield these days. It's return of principal. And over periods of two years or more, bonds--high-quality, short-, and intermediate-term bonds--have been enormously reliable. But I do think that it's worth thinking about the interest-rate sensitivity of the bond holdings you might have in your portfolio. I've often referenced what is called kind of a "duration stress test," where you're finding the duration of a bond fund in your portfolio and you're subtracting out its yield because you get the yield. And the amount that's left over is roughly the amount that you might see that fund lose in a one-year period in which interest rates went up by 1 percentage point. A big jump up in interest rates, but nonetheless something to kind of run your holdings through. I think that if investors run their bond holdings through this math, they're likely to come around to the thought that, "Yes, I might lose a little bit of money in my bond fund, but it's not going to be catastrophic. It will be nothing like what equities have the potential to lose in a really bad bear market."

Dziubinski: Let's talk a little bit specifically about the equity portion of someone's portfolio. Are there strategies that investors should be thinking about to reduce the risk specifically in that stock portion of their portfolio?

Benz: I think the key thing that you're looking for is diversification within your equity holdings. So, you want that style box diversification. You don't want overconcentration in individual stocks or in sectors. So, that's the key way to help mitigate risk. We've had a long-running rally in large-growth stocks. They've been at the epicenter of recent market volatility, but over the past three- and five-year periods, they have way outperformed value. If investors haven't taken a look at addressing their style box exposure, I think that's a good place to look today. And then, especially people who are older and drawing from their portfolios, they might look at certain strategies, think about emphasizing, say, dividend growth stocks as a portion of their portfolios, because they do tend to have a bit lower volatility than the broad market. So, that gives them a way to participate in the equity market gains but with slightly lower levels of volatility. So, there are things you can do around the margins as well.

Dziubinski: And then, Christine, what about some other asset classes or alternative investments that maybe are meant to take the edge off when both stocks and bonds aren't doing very well. What do you think of those?

Benz: Yeah, alternatives haven't had a great run, and arguably, they just haven't had a great environment to shine--because we have had such strong gains from traditional assets, that's not really when you would expect to see alternative assets perform well. But I do think that most investors, if they want to keep their portfolios pretty plain-vanilla and pretty low-cost, they will do fine as long as they mind the time horizon for their portfolio's allocations. They probably don't need a dedicated allocation to alternative assets. The products have tended to be somewhat high cost and, at the end of the day, have tended to deliver a risk/reward profile, kind of, between stocks and bonds. So, I don't see them as must-have categories for investors. But for investors who want to maintain a small allocation to an alternatives fund, it's probably not a disaster either if it gives them peace of mind and gives them a sense of comfort with their portfolios.

Dziubinski: Christine, thank you for your time today and for your tips for how to think about volatility, whether it's short term or longer term, in your portfolio. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski. Thank you for tuning in.