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A 5-Point Portfolio Risk Checkup for Investors

Christine Benz
Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five.

Market volatility has picked up in recent weeks due to a variety of factors. Sitting in this week for Jeremy Glaser to discuss the five risk factors that should be top of mind for investors is Christine Benz, our director of personal finance.

Christine, thanks for joining me.

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

Stipp: There has been no shortage of things causing market volatility. We've had interest rate concerns. We've had Greece and Puerto Rico. We've had China. At some points, all of these in the same day; that happened this week.

But it's rarely a good idea to upend a portfolio plan just because we hit some turbulence in the market. However, you say that this can be a good time to do a quick and dirty audit of the risks in your portfolio. You're going to run through some of those today.

The first risk factor you should look for is too much equity exposure in your portfolio. How do you know what is "too much"?

Benz: Ideally, you'd be operating with some sort of an asset allocation framework that makes sense for you given your life stage. Some folks may say they don't have such a blueprint, at which point I would say it makes sense to get one. Make sure that you are operating with some sort of a plan, because if you don't have a plan you are just going to be responding to headlines, and that's usually not productive.

I often advise people who don't have such a framework to look at our Lifetime Allocation Indexes as a starting point, or maybe a good target-date fund that's geared toward someone in your same age band. Those are good very basic pieces of asset allocation guidance that you can use.

Compare your current asset allocation using Morningstar's X-Ray functionality with that target and see where you are. Chances are, if you've been very hands-off over the past few years, that's been a good thing in that equities have performed well, and if you haven't trimmed them back, that's been to your credit. But I think it's probably a good time for investors who haven't done anything to think about rebalancing. Many portfolios are probably too heavy on equities given the investor's life stage, and those equities could use some trimming. Use that big-picture blueprint is a starting point for figuring out what to do next.

Stipp: So even if you set up your asset allocation a few years ago, it's important to check and make sure you are still on those targets.

Risk factor number two is exposure to risky geographies. It seems like there is no shortage of those. But there are different risks to consider maybe for each of them. Let's start with the big one, which is China. What should you be thinking about with your exposure there?

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Benz: China is actually a pretty big presence in a lot of portfolios these days. If you have some sort of an emerging-markets equity fund, Chinese stocks may be about 20% of your total exposure. That's the case if you have an emerging-markets index fund, for example. It might even be upwards of 20%.

So check up on your China exposure. It's probably too late to dramatically try to reduce emerging-markets equity exposure. They've been clobbered pretty hard just over the past couple of weeks. But if you have outsized exposure to either China or emerging markets more broadly, know that that could bring more volatility to your portfolio in the months and years ahead.

Also bear in mind, the closer you get to retirement, the more you want to try to scale back on your foreign-stock exposure generally, especially if that foreign-equity exposure is unhedged, meaning that you are bearing the full brunt of any currency swings. You want to be careful that you aren't gorging on either emerging markets or unhedged foreign stocks generally.

Stipp: So it's not that you don't want global exposure, …

Benz: No, you absolutely do.

Stipp: You want to have the right amount depending on your situation.

What about Greece? Is that a big risk concern in most people's portfolios?

Benz: It really is not. Direct Greece exposure would tend to be pretty limited, certainly in most equity or even fixed-income portfolios today. But we have seen significant repercussions from the Greek situation for a whole host of different areas--Europe, in particular, obviously.

Bear in mind that Europe stocks will typically be the largest component of any sort of foreign-equity fund. Europe is about 20% of the FTSE Global All Cap Index today. Recognize that your portfolio will feel some volatility when Greece is stumbling as it has been recently. So even if you don't have direct Greek exposure, you will tend to experience some volatility that goes along with it.

Stipp: And Puerto Rico is popping up in the headlines recently as well, and that could be an issue with some muni funds.

Benz: Absolutely. I think this may come as a surprise to some muni investors, but muni funds actually have quite a bit of latitude to invest in Puerto Rican bonds, as Russ Kinnel outlined in a recent video for us. Some of the single-state municipal bond funds actually had very sizable Puerto Rico exposure.

Here is another situation where it's probably too late to try to remedy that. If you had one of those funds that had outsized exposure to Puerto Rico, it's probably too late to scale back on it. But I think it is a good reminder that any time you see a fund type that has an appreciably higher yield than its competitors, get in there and see what sort of risk factors could come along with that higher yield. Given that yields have been so low for so long--every rock has been turned over in that search for yield--it's difficult to find a higher yield without taking on some sort of additional risk.

Stipp: Third point in my risk audit is to check for interest rate exposure, having too much interest rate sensitivity. How do I know when it's too much?

Benz: Starting with your fixed-income exposure, do that duration stress test we've talked about. I wrote an article about this topic as well. Find the duration figure that goes along with your bond fund, and find the SEC yield. Subtract the SEC yield from duration, and the amount left over is the rough amount that you might expect to see that fund lose in a one-year period in which interest rates went up by 1 percentage point.

That's a quick and dirty duration stress test that you can use for high-quality bond holdings, but I don't think you want to limit your checkup on interest-rate sensitivity to your fixed-income holdings. In fact, one thing that we saw earlier this summer is interest rate jitters were apparently weighing on the market. We saw some of the interest-rate sensitive equities fall even further than bonds.

Stipp: Utilities.

Benz: Utilities had a terrible run. REITs suffered. So, take a look at what kind of interest rate sensitivity may be in your equity holdings; those holdings might be more sensitive to interest rate changes than perhaps you thought.

Also bear in mind, going back to fixed income, people historically have thought of lower-quality bonds as being somewhat better situated in a rising-rate environment. Given that the yield differential between high-quality and low-quality bonds is razor thin these days, certainly relative to historic norms, you want to bear in mind that even those low-quality bonds could get shaken up in a rising-interest rate environment. So take a look at that as well. They won't necessarily be impervious.

Stipp: You mentioned low-quality there with respect to bonds. Risk factor number four to check is the quality of your portfolio. A lot of junkier investments have done pretty well recently, but you want to be aware if you've got lower-quality stuff hanging out with your investments.

Benz: Right, and this is another issue that I think cuts across the equity and fixed-income markets. On the fixed-income side, checking up on your credit quality exposure is fairly simple work. If you've got some sort of a dedicated junk bond or maybe even a bank-loan investment, you can see what your percentage weighting looks like there.

If you have higher-quality bond portfolios, one thing we've seen is that many of them are venturing into some--maybe not junk bonds--but some of the lower-quality investment-grade bonds. So take a look at how your portfolios are arrayed across the credit-quality spectrum. We do provide that information on the website.

Turning over to equities, I think you want to take a look at whether you have perhaps too much exposure to low-quality stocks. And there I think an invaluable feature on our website is on the Premium Details part of a [mutual fund's] portfolio tab. You can look at the financial health grade for a fund, a whole mutual fund, and you can also look at what's called the debt-to-capitalization ratio. That essentially lets you know how leveraged the companies in a given fund portfolio are.

For just a little bit of context, the S&P 500 currently has a debt-to-cap ratio of about 34%-35% today. A lower-quality portfolio, or highly leveraged portfolio like Fidelity Leveraged Company Stock, has about a 50% debt-to-cap ratio. Use that as a rough guideline to see whether your equity exposure may be low-quality in nature as well.

As we move into the late innings of whatever equity market rally we are in, we usually see the low-quality stocks hand it off to the high-quality stocks, which then go on to outperform, especially if there is some sort of a sell-off. You want to be careful. If you're looking at your portfolio today, it's probably reasonable to shade your overall exposure to the higher-quality companies.

Stipp: Lastly, Christine, you say that when you're thinking about risk, think about your own complacency. It's easy to feel like you're a good investor when the markets have gone up as well as they have over the last five-plus years. But that can also be a dangerous thing. It doesn't mean that there weren't risks, even if risk didn't bite you recently.

Benz: I think that complacency is probably the single biggest risk facing most of us today, because it's been very easy to let our winners ride. We've been rewarded for letting our winners ride. But I do think you need to be careful. What has worked in the recent past, or certainly over the past five years during this rally, may not work on a going-forward basis. Be careful not to rest on your laurels. Make sure that you have some sort of a disciplined program in place whereby you're doing this rebalancing. You don't want to be checking up on your portfolio too often, but rebalancing or at least seeing if rebalancing is warranted once a year is generally a pretty good strategy.

Stipp: Always good to think about risk before you need to think about risk. Christine, thanks so much for joining me.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.