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ETF Specialist

Easy Ways to Manage Risk

Don't overthink it.

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Earlier this year, U.S. stocks entered their 11th year of a bull market that began in March 2009, making it one of the longest of the past century. A decade into a generally benign market environment, it can be easy to forget that investing is risky. It always has been, and always will be. But risk can be managed. Here, I will share some simple ways to cut back on the amount of risk in your investment portfolio.

The Stock-Bond Mix
Bonds are far less risky than stocks. But deciding how much of each to own depends on a host of variables--most notably your capacity and willingness to bear the risk of stocks.

The relationship between stocks and bonds provides some insight as to how we can think about the stock-bond mix. Exhibit 1 shows the historic risk/return relationship of portfolios created with various combinations of stocks and bonds. The point in the upper right-hand corner represents a 100% stock portfolio and the point on the lower left a 100% bond portfolio. Each dot along the line represents a 10% incremental shift between stocks and bonds. It was created using historical returns for the MSCI World Index (global stocks) and the Bloomberg Barclays U.S. Aggregate Bond Index from 1976 through 2018. The portfolio was rebalanced annually.

The risk and return numbers have been removed because they aren't important--the future won't look like the past. The shape of this curve is far more important because it shows how the risk/return relationship changes across various mixes of stocks and bonds. Broadly speaking, holding more bonds lowers the risk (and return) of a portfolio.

Exhibit 1: Risk/Return Relationship Across Various Combinations of Stocks and Bonds, January 1976 through December 2018

 Source: Morningstar Direct and author's calculations.

But there are some interesting nuances at the extremes. For starters, a 100% bond portfolio isn't the least risky option. Holding more bonds can reduce a portfolio's overall risk because bonds are less risky than stocks. But the prices of stocks and bonds also behave in different ways. That diversification feature can further reduce a portfolio's risk in some interesting ways.

First, consider the most-risk-averse investors--those who prefer the all-bond portfolio at the lower left-hand corner of the curve. Diversifying their portfolio into a small amount of stocks can actually help further cut down on risk. The least risky portfolio in the plot above has a 90% allocation to bonds with the balance in stocks.

At the other end of the chart are the most aggressive investors--those who hold 100% stocks in order to maximize their return. These investors aren't likely to improve their returns by holding bonds. Instead, the benefit of a small bond allocation is a dramatic reduction in risk as compared with the small amount of return that one forgoes.

Regardless of where one falls along this curve, choosing a bond fund doesn't need to be a difficult exercise. Simple, low-cost core bond funds, like those listed in Exhibit 2, are easy ways to access a wide mix of bonds of different maturities from various issuers, and all of them can effectively diversify a global-stock portfolio.

Stick With Treasuries
U.S. Treasury bonds are backed by the full faith and credit of the U.S. government, making Treasuries one of the safest financial assets around.

Treasuries carry almost no default risk, so future interest-rate changes are their main source of risk. If interest rates increase, Treasury prices will decline in order to provide a proportionally higher yield. Bonds with longer maturities have more potential to experience interest-rate changes, so they tend to be riskier than those with shorter maturities.

There are a number of funds that focus exclusively on U.S. Treasuries. One option is to simply hold a fund that broadly represents the market, like  iShares U.S. Treasury Bond ETF (GOVT). This fund, which has a Morningstar Analyst Rating of Bronze, holds Treasuries with maturities ranging from one to 30 years, and its fee is low relative to other funds in the intermediate government Morningstar Category.

Fund providers like Vanguard, BlackRock, and Schwab also slice the Treasury market into separate maturity sleeves. This allows investors to focus on specific segments of the Treasury market and more precisely target the amount of interest-rate risk that they desire. Exhibit 3 lists a number of low-cost Treasury funds across a range of different maturities, seven of which are Morningstar Medalists.

Reduce Currency Risk
Bonds aside, there are additional opportunities to reduce risk within the confines of investors' equity allocations, particularly among foreign stocks.

Stocks listed overseas can complement those from the United States. They offer access to a wider array of publicly traded companies, and they don't always move in the same direction as the U.S. market. So, it makes sense to include them as part of a globally diversified portfolio.

But foreign stocks also carry an additional layer of currency risk, which stems from changes in foreign-exchange rates between the U.S. dollar and foreign currencies. There are two ways to deal with this risk. The first is to use a currency-hedged fund that attempts to eliminate currency risk. While effective, there is a limited menu of strategies, the few that exist often charge a little bit more for the hedging feature, and the forward contracts used to perform the hedging function can trigger capital gains distributions.

Another way to manage currency risk is to simply reduce your allocation to foreign stocks. To provide some context, foreign stocks have represented roughly half of the global stock market over the past several decades and accounted for 45% of the MSCI All-Country World Index as of May 2019. Simply holding less than that fraction within a portfolio's stock sleeve will reduce your exposure to this uncompensated risk.

Reconsider Emerging Markets
Not all foreign stocks are created equal. Those listed in developed markets like the United Kingdom, Germany, France, and Japan generally rest on solid footing. The underlying market and regulatory environments in these countries are mature and robust.

Those characteristics don't always carry over to emerging markets, so conducting business in these regions can be more difficult. Furthermore, developing nations can also bear political risk, as various governing regimes come into or out of power. As a result, entire markets can enter or leave major emerging-markets benchmarks. Argentina is the most recent example. The MSCI Emerging Markets Index booted Argentine stocks in 2009 when President Cristina Fernandez de Kirchner made access more difficult for outside investors. The index then reverted in 2019, welcoming these stocks back to the fold. [1]

Another unsavory aspect of emerging markets is the prominence of state-owned enterprises--companies that are partially owned by their sovereign government. Government ownership introduces the potential for conflicts of interest to arise, as governments can use their ownership stake to influence business activities for political reasons rather than prioritizing the interests of public shareholders.

These are among the additional risks that investors are exposed to when investing in emerging markets. Perhaps the easiest way to deal with the risks of these stocks is to simply forgo them. There is no rule that requires owning stocks from these regions. Collectively, they make up about 10% of total global market capitalization. So, you aren't missing out on a significant opportunity should you take a pass on these companies. Exhibit 5 lists low-cost developed-markets funds that are well suited as core foreign-stock investments.

All of these ideas can help reduce risk, but the mix between stocks and bonds will likely be the most influential on a portfolio's overall volatility. The other suggestions can help fine-tune the risks that a portfolio is exposed to. When deciding on the allocations to stocks or bonds, or what specific assets to hold, it may be helpful to think about your level of comfort when they inevitably decline--because they eventually will. Along those lines, simply not looking at your account when financial markets turn ugly can be an effective way to manage risk because it reduces the chance of making rash decisions that will harm long-term outcomes. Ignoring your investments may be the most effective risk-management tool of all.

1. Global Financial Data. 2019. "Argentina: The Ever-Emerging Market." https://www.globalfinancialdata.com/argentina-the-ever-emerging-market/.

Daniel Sotiroff has a position in the following securities mentioned above: VEA. Find out about Morningstar’s editorial policies.