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A Risk Drill for Your Portfolio

How to assess the big portfolio risk factors, including falling short and not diversifying properly.

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Note: This article is part of Morningstar's May 2016 Risk Management Boot Camp special report.

As of this writing, the yield on a three-month Treasury bill--often called "the risk-free rate"--is about 0.22%. Assuming rates remain that low, $10,000 saved today will be worth ... wait for it ... $10,681 in 30 years.

Clearly, we all need to take some risk if we're to have a shot at reaching our financial goals. That can mean owning plenty of equities--even later in our investment careers--and embracing securities that entail plenty of volatility on a standalone basis. What matters most is our total portfolio's risk level. Do the constituent holdings counterbalance one another, performing well (or poorly) in different market environments? Is the portfolio sufficiently diversified so problems in one security or sector don't bring down the whole ship? And finally, is the total portfolio well-positioned to confront the mother of all risks, falling short?

As you assess whether your portfolio's risk level is appropriate given your goals and life stage, here are some of the key questions to home in on, as well as details on how to find the answers. (Note that we'll cover risks specific to certain asset classes--such as overvaluation risk in equities or too much low-credit-quality exposure for bonds--later this week.)

Question 1: Is there a risk of falling short?

This is the mother of all risks: not having enough money to fund your goal (retirement, for most people), or perhaps even worse, retiring and then running out of money. Because the risk of falling short carries such enormous repercussions, the centerpiece of any portfolio checkup should be a "wellness check"--an assessment of whether you're on track to reach your goals given your current investment mix, your current and future savings, and your time horizon. A basic savings calculator like Morningstar's can help you see if you're in the right ballpark; just be sure to use a realistic rate of return. (I'd use 4% for a balanced portfolio.) T. Rowe Price’s Retirement Income Calculator, Vanguard's Retirement Nest Egg Calculator, and Flexible Retirement Planner are also good (and free) tools. If it turns out you have a looming shortfall, a combination of portfolio shifts and lifestyle decisions (such as being willing to retire a few years later) can help you bridge the gap. And the earlier you realize you may fall short, the more flexibility you'll have to make a save.

Question 2: Is the asset mix appropriate given life stage?

Is your asset allocation too risky? Because stocks will tend to return more than other asset classes over long periods of time, investors might naturally assume that loading up on them is the way to go. And it's true that younger investors with steady incomes should generally employ the highest equity weightings they can tolerate; over long periods of time, they'll tend to be rewarded for being willing to put up with day-to-day and year-to-year fluctuations, and those fluctuations shouldn't bother them too much given that they don't have an imminent need for their money.

But there are two key reasons a portfolio's asset allocation can be too risky. The first is if the portfolio is so volatile that the investor could be inclined to retreat to a more defensive position at an inopportune time. The second is if the portfolio's asset mix exposes it to violent swings in value (especially downward) when the investor is getting close to needing the money. Circumventing that risk is the key reason that most retirement portfolio "glide paths" begin to skew more bond- and cash-heavy for people in their 50s, 60s, and beyond. Morningstar's X-Ray tool can help you see your portfolio's true asset allocation. This article discusses setting and fine-tuning your portfolio's asset allocation mix; this one discusses the virtue of reining in your portfolio's equity weighting as retirement approaches.

Question 3: Will inflation take a big bite out of returns?

This risk factor goes hand-in-hand with the portfolio's asset allocation. Inflation isn't generally a big deal for portfolios with high equity weightings; over long periods of time, stocks will usually deliver a return that's comfortably above inflation, and when inflation is on the move, stocks are often trending up, too. But inflation risk looms large for portfolios with sizable allocations to bonds. Because bonds' income is what it is, regardless of inflation, it will buy less and less if the costs of goods and services trend up. Thus, bond-heavy investors should work hard to ensure that their portfolios include ample exposure to investments with the ability to keep up with, if not out-earn inflation, including stocks and Treasury Inflation-Protected Securities, which have a built-in hedge against inflation. This article details some of Morningstar's favorite inflation-fighting investments.

Question 4: Is the portfolio riding on a single outcome?

Stocks? Check. Bonds? Check. All-weather portfolio? Not so fast. Even portfolios that are dispersed across these two major asset classes may not be all that well-balanced. That's because lower-quality bond types respond to the same forces that stocks do--specifically, the overall health of the economy. That's fine as long as GDP growth is increasing and unemployment is on the decline. But when investors are feeling skittish about the economy, they tend to dump credit-sensitive bond types right along with their stocks. In the financial crisis, for example, categories like high-yield, bank-loan, and emerging markets bonds all tumbled, because investors worried about the creditworthiness of their issuers in a weakening economy. These bonds' losses weren't as high as equities, but nor did they provide any ballast for investors' depressed equity holdings. Thus, another check on your portfolio's overall risk level is the complexion of your fixed income holdings, as discussed here. Even though credit-sensitive bonds typically provide better yields, high-quality bonds are the better way to diversify stock-heavy portfolios.

Question 5: Is the portfolio overly concentrated?

Packing too much into an individual holding won't be a big risk for most for most mutual fund or ETF investors, assuming they don't go overboard with a single concentrated fund or two. Rather, it's more of a risk factor for investors who own at least some individual securities. Newer investors often start out with just a small handful of stocks; sometimes they get lucky, but oftentimes they learn the hard way about the dangers of underdiversification. Concentration risk can be particularly problematic for holders of company stock, as Morningstar Investment Management's head of retirement research David Blanchett discussed in this video.

Question 6: Are you a risk factor?

Last but not least, one of the biggest risk factors for many portfolios doesn't lurk inside. Rather, it's the chance that despite your well-laid plans, you'll undermine your results by falling into the fear-greed cycle, or one of the many other behavioral traps discussed in this article. Such mistimed buying and selling can exact an even bigger toll than investment fees over time. We're all wired differently as investors, so unfortunately there's no one-size-fits-all way to short-circuit behavioral risk factors. However, a few simple steps can help. First, follow Jack Bogle's advice and "don’t peek" at your portfolio or its value; assuming the plan you started with was reasonable, a policy of benign neglect will tend to beat one that's overly busy. Second, consider an all-in-one investment type that allows you to be truly hands-off. While it's still early days for target-date funds, Morningstar's investor return data paint a promising picture of investors' propensity to use such funds well--that is, they tend not to jump in and out of them so they're able to take home a good share of their returns. Last but not least, put as much of your plan on autopilot as possible, automating your ongoing IRA and taxable account contributions, just as is the case with the money going into your 401(k) plan. Not only does such a program instill discipline in your saving and investment habits, but it creates barriers that you'll need to jump over if you decide you want to stop investing when the market gets rough.

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.