Wake-Up Call on 'Sleep at Night' Investing

Jason Stipp: I'm Jason Stipp with Morningstar. A nice 50-percent-plus run off of March lows certainly helps to take the edge off. But I know that for myself and for a lot of people out there, we're still not quite back to that level that we were before the credit crisis. Which brings the question to mind of risk and how much risk can we tolerate in our portfolios?

Here to talk about some ways you can think of risk is Christine Benz. She is Morningstar's director of personal finance. Thanks for joining me again, Christine.

Christine Benz: Hi Jason, nice to be here.

Stipp: The credit crisis and what we saw a year ago when Lehman Brothers collapsed, we saw some extreme volatility, a lot of securities moving in the same direction at once. And I think that a lot of investors are wondering, after we have gotten through that, looking forward should we be thinking about risk differently? Are the riskier assets in our portfolio even riskier than we thought before? And how should we recalibrate our risk tolerance based on this last crazy year in the market?

Benz: It is a great question, Jason. And as some pundits have said, we seem to have these once-in-a-lifetime, catastrophic market events every couple of years over the past decade. So a lot of people who think about asset allocation, and think about how to structure portfolios, are in fact incorporating the possibility for some of these so called "fat tail" events to happen with a greater degree of frequency.

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It is something to think about, but you probably don't want to get overly carried away. Even if you are someone who is in retirement, you probably do need some stocks in your portfolio to account for the fact that you could live another 15, 20, 25 years during retirement.

Stipp: For me personally, how can I figure out what my personal tolerance for risk is based on my situation and taking my own portfolio into account? How do I begin to personalize that?

Benz: Investors have been schooled in this idea that you need to evaluate your own risk tolerance, think about how much you could be able to withstand in terms of losses. And I think that that discussion has probably been anchored too much in emotion and asking investors to assess whether they could sleep at night and so forth.

When in reality, I think a more useful way to frame the debate is to think about how much of a loss could I withstand without having to recalibrate my plans, or change my quality of life? If I am a retired person, for example, and I lost X amount, would that require me to change my standard of living?

Those are the kind of questions you want to be asking, versus thinking about how you would feel emotionally if you lost a certain amount.

Stipp: And certainly "sleep at night" is something that you hear a lot in the portfolio planning realm. And I think it is very short term in some ways because you think, if my portfolio were to go down a certain percentage in a day, or in a week, I wouldn't be able to sleep at night. But also maybe something that should be keeping investors up a little bit is the long-term growth potential in their portfolios, and that they need to have some aggressive, or more aggressive securities perhaps to last them for the longer term.

Benz: That is exactly the point. I think the big kahuna of risk really is running out of money and being forced to move back in with your kids, or rely on friends and family if you need nursing home care, or something like that.

I do think that right now a big risk for investors is actually being too conservative and holding too much in cash, too much in very short-term investments. Yes it feels good, yes you may be able to sleep easy, but you also are really heightening your risk of running out of money, particularly given the prospects for greater inflation down the road. That inflation could gobble up every bit and then some of whatever meager return you are able to earn on cash right now.

Stipp: If I am thinking about risk, perhaps in retirement, how can I maybe manage it a little bit so that I make sure my money can last but I also have the money that I need right then if I am living off investments?

Benz: I think it can be really helpful to think in terms of when do I need the money? For money that I need within the next, say one to two years, or fewer than two years, you obviously want to have that money in very safe liquid investments, so CDs, money markets and so forth.

Two to five years maybe you can take on a little more risk in a high-quality short- or intermediate-term bond fund. Five to 10 years, that would be money that you would be tapping within five to 10 years, maybe that can be money that is split between stocks and bonds. And then 10-plus years that could perhaps be the stock-only portion of your portfolio.

I think by anchoring it in terms of this idea of when do I literally need to begin tapping those assets can help you determine what is the right asset allocation for you during retirement.

Stipp: Some of that money that you won't need for a long time you put it in a bucket, where if there is some volatility in those stocks, in that portion of my portfolio, I am not necessarily going to worry about that too much because I know that is my longer, way-out-in-the-future money and that I have some money closer to the time I need it. And that is going to be in safer investments so I don't have to worry so much about that. I know it will be there with more certainty when I need it in that shorter term.

Benz: Exactly. And I think by adopting a mind-set like that, you would have been in a much better position to have not freaked out in 2008 when the market was going down. If you knew that this is money that I will not need for a number of years, you might have been able to withstand that market panic that we all faced.

Stipp: Thanks so much for your insights Christine; it was great talking to you today.

Benz: Thanks Jason.

Stipp: For Morningstar I am Jason Stipp, thanks for watching.