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Simple, Effective Ways to De-Risk a Portfolio

What is it, who should do it, and why?

Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar.com. The market has taken a volatile turn recently with strong up days punctuated by periodic swings downward. Joining me to discuss some simple ways to de-risk your portfolio is Christine Benz. She's Morningstar's director of personal finance.

Christine, thank you for being here today.

Christine Benz: Susan, it's great to be here.

Dziubinski: Now, let's discuss de-risking at a very basic level. What does it mean, and why would you do it?

Benz: Well, the basic idea is that you're going to look at your portfolio where it stands today and see if you aren't, in fact, courting too much risk relative to where you are in your life stage. So, typically, the biggest way that we court risk in our portfolios is by having too much equity exposure, given our proximity to needing to draw upon that portfolio. Having a very high-risk, equity-heavy portfolio makes a lot of sense for younger investors but if you're getting close to drawdown, you'd probably want to start to peel back on the equities.

Dziubinski: Do you think most people these days should be scaling back their equity exposure?

Benz: It really does come back to life stage. So, I would say for people 20s, 30s, 40s, maybe even young 50s, who still think they'll have another 15 to 20 years of work, probably not a reason to get in there and monkey around too much. They might want to focus a little bit on their intra-asset-class exposure, so maybe steer some money to foreign and away from U.S.

On the other hand, people getting close to retirement or people who are already in drawdown mode in their portfolios, those are the ones who I think should take a look at de-risking. If they haven't done so, if they've been hands-off with their portfolios, they've enjoyed nice equity gains, but their portfolios might be courting a little bit more risk than would be ideal.

Dziubinski: And making any changes or monkeying around does have tax consequences often, right?

Benz: It does. So, if you are making changes within the confines of your tax-sheltered accounts, your IRAs, your company retirement plans, you can make changes to your heart's content and not have to worry about triggering tax consequences as long as those assets stay within the confines of those accounts. But once you're touching your taxable accounts, and specifically if you're stripping back appreciated securities, well, there you could have capital gains. So, generally speaking, if you need to make changes, if you need to de-risk, focus on those tax-sheltered accounts, first and foremost.

Dziubinski: Now, let's say, I've looked at my portfolio, and I say, "OK, yes, this is a little too aggressive, this is a little too risky for where I am in my life stage." Let's talk about some simple ways I can de-risk a little bit. One is to direct new money to underweight positions in my portfolio.

Benz: That's right. So, if you are making ongoing contributions, you might say, well, I'll just send the new money to the safer securities. Maybe I'm underweight bonds. So, I'm going to turn off my contributions to the equities and send them all into the bonds and cash going forward. That can be a good strategy, although it may be difficult to move the needle if your new contributions are small as a percentage of your total portfolio. But another feather in the cap of that strategy is that if you're talking about taxable accounts, well, there's a good tax-efficient way to try to get your taxable account moving in the right direction--that by directing those new contributions to the safer securities, that's not going to trigger in any sort of taxable event in the way that selling would do.

Dziubinski: Now, what about looking at our asset-class exposures? It's not always a matter of directing new money or making changes at the asset-class level; it can be within asset classes, right?

Benz: That's right. So, in addition to de-risking at the asset-class level, you could look at the complexion of your equity holdings and of your bond holdings. So, for example, if you've been letting things ride, you maybe got a little more going in the large-growth, mid-growth, small-growth squares of the style box than would be ideal. You might have a little bit of a bet going on those aggressive areas. You may consider restoring balance and sending some money to the value side of the style box, which hasn't performed as well. You might also look at funds that just tend to do a good job of playing defense within their categories. So, I would call out some of the dividend growth strategies we've been talking a lot about on our team in the wake of Vanguard Dividend Growth reopening. Those are strategies that have historically outperformed other equities in weak markets. So, you can think about making some tweaks around the margins of your portfolio to try to reduce risk in that fashion.

Dziubinski: Another strategy would be to simplify and focus on maybe a target-date fund or a balanced or asset-allocation fund in an effort to de-risk?

Benz: Right. This can be a way to certainly get a temperature check on what an appropriate asset allocation looks like for someone at your life stage. Now, target-date allocations aren't right for everyone. But they can be really nice hands-off holdings for investors who aren't comfortable maintaining the risk exposures in their portfolios on an ongoing basis. They can also be really nice choices for smaller portions of your portfolio. So, for example, maybe most of your assets are in your company retirement plan. But you have this small IRA over here, and you've been kind of maintaining separate stock and bond positions. Well, there's a really good use for a target-date fund to simplify that portion of your portfolio. So, you don't have to put your whole portfolio in a target-date or an all-in-one fund. But it is a nice way to get yourself in the right ballpark in terms of asset allocation and also ensure that those risk exposures are kept in check on an ongoing basis, because the manager is doing that work for you.

Dziubinski: Right. Now, another technique that sort of does something similar in a 401(k) plan are these automatic rebalancing features, which we're seeing more and more of in plans?

Benz: That's right. We are seeing them more, but they aren't in every 401(k) plan. But the basic idea is that you're delegating the responsibility for keeping your risk exposures in check to your plan manager. So, you want to read the fine print about how they're doing that rebalancing. But it is a nice way to make sure that the equity exposures in your portfolio don't get away from you--that they're periodically streamlining the equity risk and they're also doing some of that intra-asset-class positioning as well.

Dziubinski: And the last strategy that you say we should be thinking about--in our taxable accounts--is not necessarily reinvesting our dividends and our capital gains but maybe taking those and reallocating them elsewhere to restore some balance in our portfolios.

Benz: That's right. And this has been top of mind for me lately, Susan, as funds are probably going to be making big capital gains distributions again later this year. This is a good way, if you've looked at your portfolio and said, "My asset allocations are a little out of whack, and this holding that's overweight is probably going to make a distribution anyway, I might as well redirect that distribution to a holding that I'd like to top up rather than sending it to this one that may be on the large side to begin with." So, this is a strategy that I think is underdiscussed. But I think it's a way that investors can plump up some of their underweight positions while stripping back things that they would rather not be adding to at this juncture. Incidentally, I would expect to see another year of hefty distributions coming from some other growth-leaning mutual funds. They've performed really well. But we continue to see redemptions from some of the active large-cap growth funds in particular. So, that might be an area if you own such a fund to consider redirecting those capital gains distributions into some other holding.

Dziubinski: Nice of you to try to find a silver lining in possibly large capital gains distributions. Great practical advice, Christine. Thank you so much.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski from Morningstar.com. Thanks for tuning in.