Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.
Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Despite the global pandemic and significant political uncertainty, investors enjoyed relatively smooth sailing in the last three quarters of 2020. But is your portfolio prepared to face volatility if and when it strikes again? Joining me today to discuss how you can find out is Christine Benz. Christine is Morningstar's director of personal finance.
Hi, Christine. Thanks for being here today.
Christine Benz: Hi, Susan. It's great to be here.
Dziubinski: As we're rolling into 2021, what are some factors right now that could make things a little bit more volatile in the coming weeks or months?
Benz: It's always hard to guess about what might be the specific catalyst for market volatility. Few people saw the pandemic coming, for example. But one thing that we do know, looking at market history, is that the market tends to be more vulnerable to these external events if stock market valuations are high. And we have had a tremendous rally in stocks: 2019 was great, 2020, surprisingly, was great, and that puts stocks at risk, at greater risk, of encountering volatility. And arguably, some of the growth-oriented stocks are particularly at risk because they have just enjoyed such a great performance run relative to the rest of the market. Stock market valuations being so high, that's really the chief catalyst for potential volatility going forward.
Dziubinski: And engaging a portfolio's readiness to deal with volatility--you suggest investors start by looking at two things, their risk tolerance and their risk capacity. Can you talk a little bit about the difference between those?
Benz: Yes. There's always so much focus paid on risk tolerance, and there are these risk tolerance questionnaires, and that's basically meant to assess: How do you feel about risk? How do you feel about volatility in the market? If the market has a really bad day, does that keep you up at night? Are you inclined to maybe make changes to your portfolio in those periods of market weakness? If so, it means that you've got a low risk tolerance and you need to pay attention to that, especially if it might prompt you to make suboptimal decisions. So, that's risk tolerance.
Risk capacity is something that I think we hear a little less about, but arguably it's more important. And basically, that means if I'm taking too much risk in my portfolio and my portfolio encounters volatility, is that going to change my plan? A great example right now is for someone who's getting close to retirement, and maybe they have a very equity-heavy portfolio that has served them well in the years leading up to retirement. But if they experience a big market shock just before retirement, well, that probably will force a change in their plan. It may, worst-case scenario, force them to forestall retirement. It could make them have to make do on a lower amount in retirement, which few retirees want to do. Or it could--if they spend too much during that period--it could mean that they run out later on in retirement. So, those are terrible outcomes, and that's the risk of having a portfolio that is too risky, given that individual's risk capacity.
Dziubinski: How can investors go about figuring out which is more important for their particular situation, risk capacity or risk tolerance?
Benz: You definitely want to consider both, but risk capacity is important. If you have any spending on the horizon in the near term, you need to stay attuned to your risk capacity and to the risk that's going on in your portfolio. That certainly applies to people who are in retirement or just embarking on retirement. But it's also important to anyone who has any near-term spending need, whether they're saving for a home down payment or college tuition in a couple years, whatever it might be, if you are anticipating spending anytime soon, risk capacity is really important. But risk tolerance is also important to keep in the back of your mind.
One of the perverse things I think in regard to risk tolerance and risk capacity is that sometimes our risk tolerance goes up later in life. We're just more experienced investors. We know that things recover. Well, guess what? For a lot of us, our risk capacity is actually declining. So, you need to pay attention to both things.
Dziubinski: If investors are attempting to assess how vulnerable their portfolios might be in the face of volatility, you say that a good place to start is with asset allocation. How can investors figure out whether their current asset allocations are in the right ballpark?
Benz: Well, you definitely want to use your anticipated spending needs to drive how your portfolio is positioned. For very young investors, to the extent that they can handle it and they don't have a low risk tolerance, they would want to have a very high equity exposure in their portfolio because spending isn't coming soon. But for people who are getting close to or in retirement, I like the idea of earmarking a portion of the portfolio that is not in stocks to help cover them through periods of market weakness that inevitably occurs. So, in my standard Bucket portfolios, which are geared toward people in retirement, we've got about eight years' worth of portfolio withdrawals in cash, in high-quality bonds. The idea is to tide the retiree through some sort of a market downturn, but definitely asset allocation will be the most important determinant of your portfolio's volatility and its risk level once you enter drawdown mode.
Dziubinski: And lastly, what other risk factors would you suggest that investors be looking for in their portfolios if they're really trying to get a good feel for how these portfolios might face volatility?
Benz: Right. I think it's really important to drill into the portfolio itself, drill into the underlying holdings. A couple of things I would call out, Susan: One is what I sometimes call faux diversification. People have bonds in their portfolio, but they're kind of the risky types of bonds, higher-yielding bonds, which, when push comes to shove, when stocks are down, they tend to behave more like stocks than they do like bonds. So, dig into that if you're someone who knows that you should have safer investments in your portfolio. Don't reach for the higher-yielding, often higher-risk securities, but instead stick with the boring, very low-yielding investments because they'll tend to hold their ground better.
For equity investors, I think it's really important to investigate the composition of their equity portfolios. During these past couple of years, we've seen a lot of investors dabbling in individual stocks. Make sure that you're broadly diversified. I have no complaint with an individual stock portfolio, but really make sure that you've got great sector exposure, that you're really covering your basis in terms of investment-style exposure as well as geographic exposure. Those are a couple of things that can bring your portfolio's risk level down.
I would also say that people can take some steps just to rein in risk by using all-in-one funds to the extent that they are appropriate with their plans. They can use balanced funds that regularly rebalance back to a target allocation. Those are other ways to bring down a portfolio's volatility level and keep you out of the equation if you feel that you're at risk of making changes that, in hindsight, might turn out to be inopportunely timed.
Dziubinski: Christine, thanks so much for your time today and your insights into how we might dampen some of the risk in our portfolios--just in case volatility is around the corner. We appreciate your time.
Benz: Thank you so much, Susan.
Dziubinski: I'm Susan Dziubinski. Thank you for tuning in.