3 Ways to Reduce Risk in a Portfolio

When a nasty head cold strikes, we know it’ll pass. Yet we’ll sip tea, pop throat lozenges, or consume antihistamine and decongestants to make us feel better--and, one hopes, speed along the healing process.

Today's volatile market is kind of like a head cold: We know it'll eventually pass, but we feel compelled to do something to make ourselves more comfortable.

Of course, overreacting to the market volatility by, say, moving out of stocks entirely can lead to bad outcomes for our portfolios and derail our goals.

"The key reason why you don't want to do that is that inevitably you will be stuck wondering when do I get back in," says Morningstar director of personal finance, Christine Benz. "Because the market often is streaky and will often log its best days on a series of short bursts as opposed to a slow, steady progression. That sort of relief can quickly be replaced with worry about, well, am I doing the right thing here and when is the best time to edge back into stocks."

Instead, Benz recommends that investors take a "light touch" with their portfolios in the face of market volatility. Here are three ways to take a little risk off the table.

Idea 1: Make Your Equity Stake More Defensive Investors of all life stages could do well to make their equity stakes a little more defensive in this volatile market, but doing so is especially important for investors nearing retirement.

"You might emphasize quality more," says Benz. "If you are an individual stock-picker, you might focus on what we call wide-moat companies. You might emphasize dividends a little more."

Several dividend-paying wide-moat stocks are trading in 4- and 5-star range, suggesting that they're undervalued--

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Among funds, we suggest investors look to those focused on dividend growth rather than those offering pure yield plays; dividend-growth funds generally favor higher-quality stocks than funds more focused on the highest yielding stocks. Some of our top picks among dividend-growth funds include Silver-rated

Benz also notes that investors might consider adding a low-volatility fund to their tool kits.

"Well-constructed low-volatility stock funds should offer better downside protection, a smoother ride, and better risk-adjusted performance than the market over the long term," says Morningstar director of passive strategies Alex Bryan. However, there's no single definition of low volatility; funds can execute a low-volatility strategy a variety of different ways. Bryan walks through the various iterations of low-volatility investing and provides a framework for evaluating these funds here. Three of his favorite low-volatility funds include Bronze-rated

Idea 2: Upgrade the Quality of Your Bonds In addition to making their stock positions more defensive, investors would do well to upgrade their bond stakes, too.

"If you are concerned about volatility related to the equity market, make sure that your bond holdings are really ballast for you, that they are going to deliver for you on days when the equity market sells off," Benz says. "That's generally high-quality bonds."

Although long-duration high-quality bonds often perform best when the stock market tanks, Benz still favors high-quality intermediate-term bonds for most investors. Longer-duration securities are exceptionally rate-sensitive and therefore aren't the best choice for investors who want to dampen the volatility of their portfolios.

Those seeking to upgrade their portfolios with high-quality intermediate-term bond funds have plenty of Morningstar Medalists to choose from in the intermediate-term government and intermediate-term bond categories, including these Gold-rated choices:

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Idea 3: Pre-retirees, Add a Short-Term Bond Fund to the Mix Lastly, Benz recommends that those on the brink of retirement add a short-term bond fund to their portfolios. At this life stage, the short-term bond fund may provide assets that pre-retirees can use to fill Bucket 1 of their portfolios once retired, that highly liquid component designed to meet near-term living expenses for the coming year or so. (Read more about Benz's Bucket Approach to retirement portfolio construction here.)

"Whereas a single intermediate-term bond fund might have been sufficient when retirement was further into the future, as retirement draws closer I think it's valuable to start building in some short-term bond funds as well," she notes. "That short-term bond fund can serve as next-line reserves if Bucket 1 is depleted and there are no obvious spots to go to refill it (i.e., it's not a good time to sell stocks or intermediate-term bonds and income distributions are insufficient)."

Some of our favorite short-term bond funds include