A 7-Point Risk Drill for Your Portfolio

A version of this article previously appeared on Jan. 25, 2021.

The right amount of risk to take in your portfolio depends on two key variables: your risk capacity as well as your risk tolerance.

Risk capacity relates to how much risk you can take without needing to change up your plan. Young people who are saving for retirement have high risk capacities. People who are about to retire have lower ones, though they still need to take some risk in order to ensure that their money will last.

Risk tolerance relates to how you feel when the market is volatile. It tends to be less important than risk capacity. But if your risk tolerance is so low that there's a chance that you'll upend your plan when the going gets tough, risk tolerance is important, too.

It's helpful to periodically audit your portfolio to ensure that it syncs up with both your risk tolerance and your risk capacity. As you conduct a risk audit of your portfolio, ask yourself the following questions.

Does my stock/bond cash mix make sense given my life stage and my proximity to spending? Your portfolio's stock/bond/cash split will have the biggest impact on its risk/reward profile, but many investors don't know where to start when it comes to setting their asset allocations.

If you don't have an asset-allocation target in mind, life stage and other factors can help you arrive at a reasonable list of asset classes. I often throw out Morningstar's Lifetime Allocation Indexes and good-quality target-date funds like BlackRock LifePath Index Target Date Fund Series and JP Morgan SmartRetirement (which are among Morningstar's top-rated target-date series) as quickie checks on the reasonableness of an asset allocation. But some investors who are saving for retirement may not be good candidates for off-the-shelf financial guidance. Retirees should their asset allocations depending on their anticipated portfolio spending, and investors of all ages should mull whether their human capital or other characteristics make them an asset-allocation outlier.

Armed with a target for your asset allocation, you can then check up on the reasonableness of your own positioning. If you have saved your portfolio in Morningstar.com's Portfolio Manager, you can use the X-Ray functionality to view your true asset class exposures. If you haven't saved a portfolio, you can use Instant X-Ray. (Clicking "Save as a Portfolio" after entering the holdings in Instant X-Ray is the most straightforward way to save a portfolio on the site; that way, you can track your portfolio's performance and allocations on an ongoing basis.)

Hands-off investors may be surprised to find that the contents of their portfolios have shifted since they initially made their allocations, even if they haven't laid a finger on their portfolios. That's because higher-risk assets tend to outearn lower ones over time; left unattended, they'll grow larger as a share of a portfolio. In weak markets for stocks, however, investors may want to top up their equity allocations to restore them to their targets.

Do I have enough cash on hand to tide me through emergency situations? In addition to checking up on your portfolio's asset class and sub-asset-class exposure, your portfolio risk assessment should include a check on your liquid reserves, which may or may not show up in your X-Ray view. (If you'd like to include cash as part of the X-Ray view of your portfolio in Morningstar's Portfolio Manager, use the symbol "CASH$" or enter the ticker for any money market mutual funds that you hold.)

For retirees, I typically recommend holding one to two years' worth of living expenses in true cash instruments. The baseline for people still working is three to six months' worth of living expenses in cash, but if you're a contractor, earn a high income, are the sole earner in your household, or work in a more specialized career path (or all of the above), you should target a year's worth of cash as an ongoing cushion.

Am I taking big risks with my equity holdings? In addition to assessing your portfolio's baseline stock/bond exposure, also check up on the complexion of your equity portfolio. Is your stock portfolio listing heavily toward value or growth, small stocks or large? Do you have a lot riding on a single sector? Here again, X-Ray can help you see how you're positioned. For a check on your portfolio's investment-style and market-cap exposure, comparing your portfolio's style-box exposure via X-Ray to that of a total stock market index fund like Vanguard Total Stock Market VTSAX can be a good check on whether you're making any inadvertent size or style bets. The X-Ray functionality also enables you to see your portfolio's sector weightings relative to the S&P 500's.

Also check up on your equity portfolio's ratio of U.S./foreign stocks. Most professional asset allocations dedicate at least 25% to a third of their equity weightings to foreign stocks.

Are my bond holdings likely to deliver in the clutch? In addition to checking the size of your bond position, also take a closer look at the types of bond holdings you own. Higher-risk bond types like emerging-markets and high-yield bonds tend to have higher yields than high-quality bonds, but they also exhibit substantially higher volatility and often move in sympathy with the economy and the equity market. That means they may not provide the same diversification benefits that high-quality bonds do. For most investors, sturdy high-quality short- and/or intermediate-term bond funds should be the linchpins of their bond portfolios; retired or soon-to-retire investors should also consider a stake in Treasury Inflation-Protected Securities.

Are high costs cutting into my returns? One underdiscussed yet easy-to-control risk is overpaying for investments. In contrast to that too aggressive holding that only costs you when stocks hit the skids, overpaying takes a bite out of your returns year after year. Investors seem to be waking up to the importance of cheaping out with their investments, as evidenced by dramatic inflows into low-cost index products, especially exchange-traded funds. Morningstar Medalist funds have been named as such with expenses as a key emphasis. But don't stop your cost due diligence at the product level. Also take a close look at any brokerage commissions, account-maintenance fees, and advisory fees that you're paying for your various accounts. Some of these expenses may be unavoidable (and money spent on good advice may be well worth it), but you want to be sure you're receiving good value for your money.

Am I ceding more to taxes than I need to? Like investment-related costs, taxes are another source of return "leakage" and, in turn, another source of risk for your portfolio. A key first step in not paying more investment-related taxes than you need to is to take advantage of all of the tax-sheltered savings vehicles that you have available to you: IRAs, company-provided retirement savings plans (SEP-IRAs or solo 401(k)s for self-employed folks), and 529s for college savings. And if you have taxable (that is, non-tax-sheltered) investments, make sure you've populated them with investments that reduce the drag of taxes on an ongoing basis.

Are my own behaviors hurting my results? This is a harder risk factor to check up on, because it's so much less tangible. But in aggregate, investors often undermine their own results because they fall prey to the greed-fear cycle: They load up on risky investments when they're performing well, then dump them after they've fallen and are potentially due for a comeback. This gets back to risk tolerance; some people are uneasy with volatility, which can lead to poorly timed portfolio changes. Morningstar's annual "Mind the Gap" study examines funds' dollar-weighted returns (that is, investors' actual profits, factoring in the timing of their purchases and sales) relative to funds' published total returns. If, after honest reflection, you know you've made investment decisions that you've regretted in hindsight, delegating your investment decision-making to a professional advisor may be money well spent. Alternatively, you might consider taking an ultrahands-off approach via a simple all-in-one stock/bond fund. Morningstar's investor return research has consistently demonstrated that investors use such products well, capturing a large share of their actual returns.

Am I doing my share? Finally, the mother of all portfolio risks is running out, either because you didn't save enough during your working years or you withdrew too much too early in your retirement. If you're in accumulation mode, the most important part of your portfolio risk assessment is a check on whether your current portfolio balance, along with expected additional contributions over your time horizon, puts you on track to reach your financial goals. Rules of thumb can be a good starting point. If you're a younger accumulator, benchmarks provided by Fidelity Investments can help you see if you need to step up your contributions.

If you’re closer to retirement, the 4% guideline is often referred to as a starting point for portfolio withdrawals, but research that my colleagues and I have done suggests that 3.3% is a better number in today’s market. Given that, check to see whether withdrawing 3.3% of your anticipated kitty at the outset of retirement is going to provide you with enough income to augment what you’re getting from certain sources of income such as Social Security and/or a pension. If you’re already retired, make an assessment of your spending rate part of your annual portfolio checkup. Comparing your total withdrawals to your required minimum distribution percentage (for tax-deferred accounts) is a way to calibrate your withdrawals factoring in both your age and your portfolio’s value.